Direct Your Learning

5
Underwriting and Ratemaking

Educational Objectives 1I Outline

After learning the content of this assignment, you should be able to: Purpose of
Underwriting
Describe the purpose of underwriting.
Underwriting
Describe the underwriting activities typically performed by line and staff Activities
underwriters.
The Underwriting
Describe the steps i n the underwriting process. Process

Given the insurance rate and exposure units for a particular insurance Premium
policy, calculate the policy premium. Determination

Describe the responsibilities of underwriting management. Underwriting

Management
Explain how individual states i n the United States regulate underwriting
activities through restrictions on unfair discrimination, cancellation, and Regulation of
Underwriting
nonrenewal.
Activities
Explain how insurance rates are developed.
Ratemaking

Summary
Underwriting and Ratemaking

PURPOSE OF UNDERWRITING
Insurance companies assume billions of dollars i n financial risk annually,
risk that is transferred to them from individuals and businesses via the insur-
ance transaction. Insurance underwriters, using the underwriting process and
various supporting underwriting tools, are employed by insurers to assess both
their new and current business. A n insurance company's overall profitability
can depend significantly on the quality of its underwriting.

Underwriting has multiple purposes. The overarching purpose is to develop

and maintain a profitable book of business for the insurer. Underwriting Book of business
is crucial to an insurer's success; underwriting goals flow directly from the A group of policies with
insurer's corporate strategies and objectives. Favorable underwriting results are a common characteristic,
necessary for an insurer's ability to sustain profitable growth. such as territory or type
of coverage, or all policies
To achieve profitability, the underwriting function serves additional purposes: written by a particular
insurer or agency.
• Guarding against adverse selection
• Ensuring adequate policyholders' surplus
• Enforcing underwriting guidelines

Guarding Against Adverse Selection

Underwriters are an insurer's guard against adverse selection. These are Adverse selection
examples of adverse selection: In general, the tendency for
people with the greatest
• Some property owners i n areas prone to coastal storms purchase wind- probability of loss to be the
storm coverage or increase their limits only before a hurricane season, ones most likely to purchase
when they expect severe losses. insurance.

• A disproportionate percentage of property owners in an earthquake-prone

zone purchase earthquake insurance, as compared to property owners i n
areas less prone to earthquakes.

Underwriters minimize the effects of adverse selection by carefully selecting

the applicants whose loss exposures they are willing to insure, charging appro-
priate premiums for the applicants that they do accept w i t h premiums that
accurately reflect the loss exposures, and monitoring applications and books of
business for unusual patterns of policy growth or loss.

• 5.3
5.4 Property and Liability Insurance Principles

Ensuring Adequate Policyholders' Surplus

A n insurance company must have adequate policyholders' surplus if it wishes
Capacity to increase its written premium volume. A n insurer's capacity is limited by
The amount of business regulatory guidelines and often by its o w n voluntary consttaints, which are
an insurer is able to frequently more conservative than those imposed by regulators. If an insurer's
write, usually based on a underwriting practices generate policy premiums that exceed losses and
comparison of the insurer's
expenses, the policyholders' surplus will increase, thereby increasing capacity.
written premiums to its
policyholders' surplus.
Underwriters ensure the adequacy of policyholders' surplus by adhering to
underwriting guidelines, making certain that all loss exposures are correctly
identified, and charging adequate premiums for the applications that are
accepted.

Enforcing Underwriting Guidelines

Underwriting authority U n d e r w r i t i n g guidelines reflect the levels of u n d e r w r i t i n g authority that are
The scope of decisions that granted to varying levels of underwriters, producers, and managing general
an underwriter can make agents ( M G A s ) . Exactly who has what level of underwriting authority varies
without receiving approval considerably by insurer and by type of insurance.
from someone at a higher
level. Underwriting ensures that applicants accepted adhere to underwriting guide-
Underwriting guidelines lines. I f loss exposures, risks, or policy limits on an application exceed an
(underwriting guide) underwriter's authority, he or she w i l l seek approval through supervisory and
A written manual that management ranks w i t h i n the underwriting department.
communicates an insurer's
underwriting policy and that
specifies the attributes of an
account that an insurer is UNDERWRITING ACTIVITIES
willing to insure.
In insurance organizations, underwriting responsibilities are delegated by
members of senior management to line and staff underwriters who coordinate
the day-to-day risk selection decisions and the management-level underwrit-
ing activities. This coordinated effort is crucial to the achievement of the
insurer's profitability goals.

Line underwriter The focus of line underwriters is evaluating new submissions and performing
Underwriter who is renewal underwriting. Line underwriters work directly w i t h insurance pro-
primarily responsible for ducers and applicants. The focus of staff underwriters is managing the risk
implementing the steps in selection process. Staff underwriters work w i t h line underwriters and coor-
the underwriting process.
dinate decisions w i t h other departments to manage the insurance product,
Staff underwriter pricing, and guidelines. See the exhibit "Underwriting Activities Performed
Underwriter who is usually by Line and Staff Underwriters."
located in the home
office and who assists
underwriting management
with making and Line Underwriting Activities
implementing underwriting Line underwriters evaluate individual accounts fot acceptability and execute
policy.
underwriting policy by following practices and procedures outlined by staff
undeerwnters The specific tasks line underwriters perform may vary by insurer;

•
 Underwriting Activities Performed by Line and Staff
Underwriters
Line underwriters Staff underwriters
Select insureds Research the market
Classify and price accounts Formulate underwriting policy
Recommend or provide coverage Revise underwriting guidelines
Manage a book of business Evaluate loss experience
Support producers and insureds Research and develop coverage forms
Coordinate with marketing efforts Review and revise pricing plans
Arrange treaty reinsurance
Assist others with complex accounts
Conduct underwriting audits
Participate in industry associations
Conduct education and training

[DA06264]

however, most line underwriters are responsible for the major activities speci-
fied in the exhibit.

established i n underwriting guidelines. They also monitor accounts to ensure

that they continue to be acceptable and may cancel or nonrenew an account
if risk control recommendations made at the policy's inception are not
implemented or if the insured fails to take cottective action to control loss
frequency. The account selection activity is essential to attaining these goals:

• Avoiding advetse selection

• Charging adequate premiums for accounts with a higher-than-average
chance of loss
• Selecting better-than-average accounts for which the premium charged
w i l l be more than adequate
• Rationing an insurer's available capacity to obtain an optimum spread of
loss exposures by location, class, size of risk, and line of business

Classify and Price Accounts

Line underwriters are responsible for account classification, which is the
process of grouping accounts w i t h similar attributes so that they can be priced
appropriately. T h e price charged must not only be adequate to permit the
5.6 Property and Liability Insurance Principles

insurer to continue to write profitable business, but also it must be competi-

tive. A consequence of misclassification is that the premium charged is not
commensurate w i t h the risk transferred.

Insurers must submit classification and taring plans to state insurance regu-
lators. For some lines of business and in some states, line underwritets may
not have any disctetionary latitude in policy pricing. I n other lines of insur-
ance, the line underwriter can use individual rating plans to apply debits and
credits to the account that will adjust the premium to reflect the character-
istics of the individual insured. The line underwriter must be sure that the
account chatacteristics justify the adjustment and must document that the
account complies w i t h the insurer's individual rating plan filed w i t h regulatory
authorities.

Recommend or Provide Coverage

Line underwriters support producers and policyholders by inquiring about
an insured's risk management program to ensure that the insured is using
other risk management techniques to address gaps in insurance coverage.
Additionally, sometimes an underwriter must narrow an insured's coverage
if a producer requests broader coverage for the loss exposures of a particular
applicant than the insuter is willing to provide.

Line underwriters also have a role in ensuring that applicants obtain the cov-
erage they request. The task of providing requested coverage often involves
collaboration w i t h the producer. Because each account is unique, producers
and applicants often want to know how coverage will respond to a specific
type of loss. Line underwriters respond to these requests (usually through the
producer) by explaining the types of losses the covetage fotms are designed
to cover and the endorsements that must be added to provide the coverage
desired. For most accounts, however, the line underwater simply ensures that
the policy is being issued w i t h the appropriate forms and endorsements that
provide the requested coverage.

Manage a Book of Business

Frequently, line underwriters are expected to manage a book of business.
Underwriting management usually reinforces departmental goals through
individual line underwriters. Some insurers also make line underwriters
responsible for the profitability of a book of business accepted from a producer,
or written in a territory or line of business. The line underwritet works to
ensure that each book of business achieves established goals, such as product
mix, loss ratio, and written premium.

Support Producers and Customers

The services that line underwriters are expected to provide to producers
and customers vary. Some insurers rely on customer service departments to
respond to routine inquiries and requests. Insurers operating through inde-

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 Underwriting and Ratemaking 5.7

pendent agents often rely o n their sales force to perform many policy service
functions. Because customer service activities and underwriting are often
interwoven, line underwriters have an active interest in ensuring that pro-
ducers' and insureds' needs are met. Line underwriters are usually directly
involved w i t h producers i n preparing policy quotations.

Coordinate With Marketing Efforts

A n insurer's marketing efforts and underwriting policy should be compatible.
That is, line underwriters should not reject applications that meet insurer
underwriting guidelines simply because of an underwriter's bias against a par-
ticular class of business.

Supporting the insurer's marketing objectives can have broader implications

for the line underwriter. Some insurers rely on special agents or field repre-
sentatives to market the insurer and its products to agents and brokers. Some
insurers have blended the responsibilities of special agents and line under-
writers into the position of production underwriter. Production underwriters
usually confer personally w i t h producers and assist them w i t h developing
accounts that are acceptable to the insurer.

Staff Underwriting Activities

Staff underwriters work closely w i t h underwriting management to per-
form activities essential for profitable risk selection, as specified i n the
"Underwriting Activities Performed by Line and Staff Underwriters" exhibit.

Research the Market

Insurers must continually research fundamental issues such as potential target
markets. Staff underwriters typically share these research responsibilities w i t h
actuarial and marketing departments. Research includes an ongoing evalua-
tion of these items:

• Effect of adding or deleting entire lines of business

• Effect of expanding into additional states or retiring from states presently
serviced
• O p t i m a l product mix i n the book of business
• Premium volume goals

Formulate Underwriting Policy Underwriting policy

(underwriting philosophy)
U n d e r w r i t i n g policy translates an insurer's mission and goals into specific
A guide to individual and
strategies that, in turn, determine the composition of the insurer's book of aggregate policy selection
business. Staff underwriters work w i t h employees from other departments to that supports an insurer's
formulate underwriting policy. N o single underwriting policy is appropriate mission statement.

•
5.8 Property and Liability Insurance Principles

for all insurers. Insurers often develop their underwriting policy w i t h i n the
context of the market(s) they serve, which could include any of these:

• Standard market—Bctter-than-average accounts for which the average

premium is more than adequate
• Nonstandard market—Higher-risk applicants, who are charged a higher-
than-average premium
• Specialty market—Accounts that have unique needs, such as professional
liability, that are not adequately addressed i n the standard market

Beyond these broad market selections, the goals for an insurer's book of
business and resulting underwriting policy may be established by types of
insurance and classes of business to be written; territories to be developed; or
forms, insurance rates (such as filed rates and surplus lines pricing), and rating
plans to be used.

Revise Underwriting Guidelines

Staff underwriters are usually responsible for revising underwriting guidelines
so that they accurately reflect changes in underwriting policy. Some under-
writing guidelines include systematic instructions for handling particular
classes of commercial accounts. Such guidelines may identify specific haz-
ards to evaluate, alternatives to consider, criteria to use when making the
final decision, ways to implement the decision, and methods to monitor the
decision. The guidelines may also provide pricing instructions and reinsur-
ance-related information. Other insurers use underwriting guidelines that are
less comprehensive.

Evaluate Loss Experience

Staff underwriters evaluate an insurer's loss experience to determine whether
changes should be made i n underwriting guidelines. Insurance products that
have losses greater than those anticipated are usually targeted for analysis.
Staff underwriters research loss data to determine the specific source of the
excess losses. Part of this research includes an analysis of insurance industry
loss experience that may reveal trends affecting the insurer's products. Based
on theit evaluation, staff underwriters, usually w i t h the agreement of othet
key departments, adjust the insurer's underwriting guidelines.

Research and Develop Coverage Forms

Advisory organization Coverage forms are developed by both insurance advisory organizations and
An independent organization individual insurers. Insurance advisory organization-developed coverage forms
that works with and on are usually constructed by coverage experts who consider the scope of cover-
behalf of insurers that age being provided, coverage provided by other policies, and legal restrictions
purchase or subscribe to its
that apply to coverage-form development. W h e n an insurer develops its o w n
services.
forms, staff underwriters collaborate w i t h the insurer's actuarial and legal
departments. Insurers develop new coverage forms to meet changing con-

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 Underwriting and Ratemaking 5.9

sumer needs and competitive pressures. Additionally, insurers modify existing

coverage forms (either their own forms or those created by advisory organi-
zations) so that the coverage being provided by the insurer will respond as
anticipated. A n unfavorable court decision, for example, may cause an insurer
to rewrite a coverage form to l i m i t the coverage being provided.

Review and Revise Pricing Plans

Staff underwriters review and update rates and rating plans continually,
subject to regulatory constraints, to respond to changes i n loss experience,
competition, and inflation. Historical loss data are gathered by the insurer
or by advisory organizations to develop prospective loss costs. T h e n , each Prospective loss costs
insurer examines its o w n operational profit and expense requirements. Staff Loss data that are modified
underwriters combine prospective loss costs w i t h an insuter-developed profit by loss development,
and expense loading to create a final rate used i n policy pricing. For any cov- trending, and credibility
processes, but without
erages for which advisory organizations do not develop loss costs, the insurer
considerations for profit and
must develop its own rates. I n such situations, reviewing and revising rating expenses.
plans become even more crucial to ensure that the loss costs adequately reflect
loss development and trending. Trending
A statistical technique for
analyzing environmental
Arrange Treaty Reinsurance changes and projecting such
Staff underwriters are responsible for securing and maintaining treaty changes into the future.
reinsurance. For many insurers, treaty reinsurance limitations are directly Loss development
reflected i n their underwriting guidelines. For example, staff underwriters The increase or decrease of
specify in the underwriting guidelines the maximum coverage limits that incurred losses over time.
can be offered when higher limits of treaty reinsurance are not purchased. Treaty reinsurance
Additionally, some types of accounts cannot be insured because the insurer's A reinsurance agreement
treaty reinsurance agreements specifically exclude the account's classification. that covers an entire
For commercial property accounts, many staff underwriters maintain a line class or portfolio of loss
authorization guide, which serves as a control on the property limits accepted exposures and provides
that the primary insurer's
based on the treaty reinsurance agreement. W h e n facultative reinsurance is
individual loss exposures
required for a particular account, the reinsurance transaction may be handled that fall within the treaty are
by either a staff underwriter or a line underwriter, depending on the insurer's automatically reinsured.
procedures. Facultative reinsurance
Reinsurance of individual
Assist Others With Complex Accounts loss exposures in which the
primary insurer chooses
Staff underwriters often serve as consultants to other underwriters. Generally, which loss exposures to
staff underwriters have significant first-hand line underwriting experience. submit to the reinsurer, and
They regularly see complex and atypical accounts, unlike most line underwrit- the reinsurer can accept or
reject any loss exposures
ers. Staff underwriters also function as "referral underwriters"—that is, when
submitted.
an application exceeds a line underwriter's authority, a referral underwriter
can review and approve the risk.

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5.10 Property and Liability Insurance Principles

Conduct Underwriting Audits

Staff underwriters are often responsible for monitoring line underwriter activi-
Underwriting audit ties and adherence to underwriting authority by conducting u n d e r w r i t i n g
A review of underwriting audits. The audits focus on proper documentation, adherence to procedure
files to ensure that individual and classification and rating practices, and conformity of selection decisions
underwriters are adhering to
to the underwriting guide and bulletins.
underwriting guidelines.
Staff underwritets also monitot underwriting activity by analyzing statistical
results by type of insurance, class of business, size of loss exposure, and terri-
tory. Statistical data show the extent to w h i c h underwriting goals are met,
but they do not conclusively demonstrate whether the tesults are a product of
implementing the insurer's underwriting guidelines.

Participate in Industry Associations

Many insurers are members of national and state associations that address
insurance industty concerns. Additionally, insurers often shate in the opera-
tion of residual market mechanisms, such as automobile j o i n t underwriting
associations and windstorm pools. Staff underwriters typically represent the
insurer as a member of these organizations. Staff underwriters may also serve
on an advisory organization's committees that study standard policy forms and
recommend changes.

Conduct Education and Training

Staff underwriters are usually responsible for determining the education and
training needs of line underwriters. Sometimes, these training needs are
addressed through a formal training program that all newly hired underwriters
must complete. A t othet times, the ttaining need is transitoty and is provided
through classes that address a specific underwriting issue or procedure.

Some training needs are met through programs provided by the insutet's
human resources department. However, staff underwriters often develop
courses and setve as instructors in technical insurance subjects.

THE UNDERWRITING PROCESS

A n underwriter engages in a series of steps and tasks to help the insurer
achieve its business goals.

The underwriting process is a series of steps and tasks incorporating these

underlying concepts:

• The purpose of underwriting is to develop and maintain a profitable book

of business.
• Underwriting activities include line underwriting activities and staff
underwriting activities.

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 Underwriting and Ratemaking 5.11

• Levels of underwriting authority ate based o n experience and knowledge.

• Underwriting policy should support an insurer's mission.

After a producer submits an application for insurance to an insurer, the appli-

cation must be qualified for acceptance. Underwriters qualify an application
by following the steps i n the underwriting process. In addition to applica-
tions, the underwriting process is also applied to renewal policies as well as
certain policy changes, such as a request to add a new location to a property
Expert systems, or
policy. I n this section, applications, renewals, and policy changes to which
knowledge-based systems
the underwriting process is applied are referred to as underwriting submis-
Computer software
sions. Typically, an insurance company underwriter makes decisions regarding
programs that supplement
underwriting submissions for commercial lines. Underwriters use expert the underwriting decision-
systems, or knowledge-based systems, to help them make better and more making process. These
consistent underwriting decisions. systems ask for the
information necessary
A l t h o u g h experienced underwriters do not always follow each of the steps in to make an underwriting
the underwriting process in strict order, the sequence of steps provides a sound decision, ensuring that no
framework w i t h i n which underwriters can make decisions. See the exhibit information is overlooked.

"Steps in the Underwriting Process." Physical hazard

A tangible characteristic
of property, persons, or
Steps in the Underwriting Process operations that tends to
increase the frequency or
1. Evaluate the submission
severity of loss.
2. Develop underwriting alternatives Hazard
3. Select an underwriting alternative A condition that increases
4. Determine an appropriate premium the frequency or severity of
a loss.
5. Implement the underwriting decision
Morale hazard
6. Monitor the underwriting decision (attitudinal hazard)
A condition of carelessness
or indifference that
[DA07556] increases the frequency or
severity of loss.
Moral hazard
A condition that increases
Evaluate the Submission the likelihood that a person
will intentionally cause or
The first step i n the underwriting process is evaluating a submission's loss
exaggerate a loss.
exposures and associated hazards. Hazards fall into four categories: physi-
Legal hazard
cal hazards, moral hazards, morale hazards, and legal hazards. Underwriters
A condition of the legal
must understand the activities, operations, and character of every applicant.
environment that increases
To evaluate a submission, underwriters perform two tasks: weighing the need loss frequency or severity.
for information and gathering the necessary information.
Information efficiency
The balance that
Weigh the Need for Information underwriters must maintain
between the hazards
Underwriters apply information efficiency to weigh the need for informa- presented by the account
t i o n against the cost to obtain it. For example, an underwriter is likely to and the information needed
investigate a chemical manufacturer extensively, but may require much less to underwrite it.

•
5.12 Property and Liability Insurance Principles

information to underwrite a gift shop. Sometimes, an account's premium

size determines the amount of information gathered or the resources used to
gather i t . A n account w i t h a small premium volume may not justify expensive
research. Underwriters may also categorize information as essential, desirable,
or available when determining whether it should be obtained.

Gather the Necessary Information

Underwriters compile information from many sources to develop a profile of
a submission. Underwriters pay close attention to a submission's hazards to
determine whether those hazards are typical of similarly classified accounts.

These are the principal sources of underwriting information:

• Producers—Underwriters rely more on the producer than o n any other

source because the producer has personal contact w i t h an applicant, has
firsthand knowledge of the applicant's business operations, knows the
applicant's reputation i n the community, and has determined the appli-
cant's coverage needs.
• Applications—Insurance applications provide general information
tequired to process, rate, and underwrite loss exposures of the applicant.
• Inspection reports—Independent inspections or risk control reports
provide underwriting information about the property's physical condition,
the business operations' safety record, and the policyholder's management.
• Government records—Government records that provide underwriting
information include motor vehicle reports; criminal court records; and
civil court records, including records of suits filed, mortgages and liens,
business licenses, property tax records, U n i t e d States Securities and
Exchange Commission (SEC) filings, and bankruptcy filings.
• Financial rating services—An applicant's financial status provides impor-
tant underwriting information. Dun & Bradstreet ( D & B ) , Standard &
Poor's, and Experian are some of the major financial rating services that
provide data on the credit ratings of individual businesses, together w i t h
industry averages for comparison.
• Loss data—Loss data, such as that contained i n loss runs, are a significant
underwriting tool for predicting future losses. The loss experience of a
commercial policyholder might be extensive enough to be statistically
significant on its o w n .
• Field marketing personnel—Insurers often employ field marketing person-
nel (such as marketing representatives or special agents) who can provide
both specific and general underwriting information.
• C l a i m files—When renewing existing policies, an underwriter can obtain
insights into the policyholder's character by reviewing the policyholder's
claim files. C l a i m representatives typically accumulate a significant
amount of underwriting information during their investigations.

•
 Underwriting and Ratemaking 5.13

Many tools are available to help underwriters evaluate, select, and price Predictive analytics
submissions. Examples of these tools include telematics, predictive analytics, Statistical and analytical
predictive modeling, and catastrophe modeling. Underwriters choose and techniques used to develop
models that predict future
balance the tools available to make the decision, which requires a holistic
events or behaviors.
understanding of all of the information available in evaluating submissions.
Catastrophe model
A type of computer program

Develop Underwriting Alternatives that estimates losses from

future potential catastrophic
The second step in the underwriting process is developing underwriting alter- events.
natives. The underwriter must consider each alternative carefully and choose Predictive modeling
the optimal one for the circumstances. The underwriter may accept a submis- A process in which historical
sion as is, reject the submission, or accept the submission subject to certain data based on behaviors
modifications. Determining the modification that best meets the needs of the and events are blended
insurer, producer, and applicant can be a challenge. There are four major ways with multiple variables and
used to construct models of
an underwriter can modify a submission:
anticipated future outcomes.
• Require risk control measures Counteroffer
• Change insurance rates, rating plans, or policy limits A proposal an offeree makes
to an offeror that varies in
• A m e n d policy terms and conditions
some material way from the
• Use facultative reinsurance original offer, resulting in
rejection of the original offer
The first type of modification for an unacceptable submission is a counterof- and constituting a new offer.
fer w i t h a requirement for the applicant to implement additional risk control
Experience rating
measures. Some risk control measures are relatively inexpensive and simple
A ratemaking technique
to implement, while others, such as fire detection and suppression (sprinkler) that adjusts the insured's
systems, require considerable capital investment. A n underwriter should premium for the upcoming
make sound recommendations accompanied by well-reasoned and convincing policy period based on the
explanations and follow up to ensure that required risk control measures are insured's experience for the
implemented and that submissions meet underwriting guidelines. current period.
Schedule rating
The second type of modification for a submission is a counteroffer to change
A rating plan that awards
insurance rates, rating plans, or policy limits. A rate modification could either debits and credits based on
increase or decrease the premium. A rate increase compensates the insurer for specific categories, such as
potential increases i n loss severity or frequency. A rate decrease might prevent the care and condition of the
an applicant from buying coverage from a competitor Good judgment plays premises or the training and
selection of employees, to
an important role in selecting a rate that earns a reasonable profit and is com-
modify the final premium to
petitive enough to obtain the account. reflect factors that the class
rate does not include.
In addition to changing rates, this type of modification also includes chang-
Retrospective rating
ing rating plans. Several rating plans are available for commercial applicants:
experience rating, schedule rating, and retrospective rating. A ratemaking technique
that adjusts the insured's
Changing policy limits also falls into this type of modification. A n insuter's premium for the current
underwriting guidelines usually specify the maximum limits of insurance that policy period based on the
insured's loss experience
an underwriter can approve. The limits usually reflect reinsurance limitations
during the current period;
or availability and possible catastrophic loss from a single loss exposure. I f paid losses or incurred
high policy limits are requested, the underwriter may suggest lower limits or losses may be used to
may use facultative reinsurance as a way of providing the requested limits. determine loss experience.

•
5.14 Property and Liability Insurance Principles

The third type of modification for an unacceptable submission is a counterof-

fer to amend policy terms and conditions. A n unacceptable submission may
become acceptable by modifying the policy to exclude certain causes of loss,
add or increase a deductible, or make another coverage change. Increasing a
deductible might make coverage more viable for a small commercial account
in which a large number of small losses has caused unsatisfactory loss experi-
ence in the past.

The fourth type of modification for an unacceptable submission is an insurer's

internal decision to use facultative teinsurance if treaty reinsurance is not
available. The underwritet may be able to transfer a portion of the liability for
the applicant's loss exposure to a facultative teinsuter. A n alternative to pur-
chasing facultative reinsurance is to ask the producer to divide the insurance
among several insurers—an approach sometimes called "agency reinsurance."

Select an Underwriting Alternative

The third step in the underwriting process is selecting an undetwriting
alternative. A n underwritet must decide whether to accept a submission as
offered, reject i t , or accept it subject to modifications. Rejection is sometimes
unavoidable; however, rejections produce neither premium nor commission,
only expense. Therefore, underwriters try to make the submission acceptable
because one of an insurer's goals is to produce profitable business.

Selecting an alternative involves weighing a submission's positive and nega-

tive features, including loss exposures contemplated in the insurance rate, risk
control measures, and management's commitment to loss prevention. These
additional factors need to be considered before selecting an underwriting
alternative:

• Underwriting authority—If the underwriter lacks authority, the submis-

sion must be referred to a higher underwriting authority.
• Supporting business—A submission that is marginal by itself might be
acceptable if the other insurance components of the applicant's account—
the suppotting business—ate desirable.
• M i x of business—The underwriting policy detetmined by management
and specified i n the underwriting guidelines frequently indicates the
Mix of business insurer's mix-of-business goals.
The distribution of individual • Producer relationships—The relationship between the underwriter and
policies that compose
the producer should be based on mutually shared goals. Differences of
the book of business of a
opinion are common, particularly because some of the goals of producers
producer, territory, state, or
region among the various and underwriters conflict when producers focus on production and under-
lines and classifications. writers focus on strict adherence to selection standards.
• Regulatory restrictions—An underwritet must be aware of state regu-
lations that restrict underwriters' ability to accept ot renew business.
Additionally, federal and state privacy laws restrict the type and the
amount of information about an applicant that an underwriter can obtain.

•
 Underwriting and Ratemaking 5.15

Determine an Appropriate Premium

The fourth step in the underwriting process is determining an appropriate
premium. A n underwriter must ensure that each loss exposure is properly clas-
sified so that it is properly rated.

Insurance loss costs are typically based o n an elaborate classification system i n

which similar loss exposures are combined into the same rating classification.
This enables the insurer to appropriately match potential loss costs w i t h an
applicant's particular loss exposures and develop an adequate premium to pay
losses and operating expenses and to produce a profit.

For most types of personal insurance, workers compensation, and some other
commercial insurance, proper classification automatically determines the
premium. For some types of commercial insurance, such as general liability,
an underwriter might have the option of adjusting the premium based on the
characteristics of the account's loss exposures.

Implement the Underwriting Decision

The fifth step i n the underwriting process is implementing the underwriting
decision. Implementing underwriting decisions generally involves three tasks:

• Communicate the decision—If the decision is to accept the submission

w i t h modifications, the reasons must be clearly communicated to the
producer and applicant, and the applicant must agree to accept or imple-
ment any modifications made as a counteroffer. I f the underwriter decides
to reject the application, he or she must communicate the rejection to the
producer in a positive way to preserve their long-term relationship.
• Issue documents—In accepting a submission, an underwriter might need
to issue a binder and prepare certificates of insurance. Binder

• Record information—Information about the policy and the applicant A temporary written or
oral agreement to provide
are recorded for policy issuance, accounting, statistical, and monitoring
insurance coverage until
purposes.
a formal written policy is
issued.

Monitor the Underwriting Decision Certificate of insurance

A brief description of
The sixth step i n the underwriting process is monitoring the underwriting insurance coverage
decision. After an underwriting decision has been made on a new-business prepared by an insurer or
submission or a renewal, the underwriter has two tasks to ensure that satisfac- its agent commonly used
by policyholders to provide
tory results are achieved: monitor activity for individual policies, and monitor
evidence of insurance.
books of business.

Monitor Individual Policies

A n underwriter must be alert to changes i n insureds' loss exposures. Changes
in the nature of an insured's business operation, for example, could signifi-

•
5.16 Property and Liability Insurance Principles

candy raise or lower the policyholder's loss potential. The monitoring of exist-
ing policies usually occuts in response to any of these triggering events:

• Substantive policy changes—Adding a new location to a property policy

or a new driver to an auto policy can cause the underwriter to investigate
whether the additions significantly change the loss exposures.
• Significant and unique losses—A notice of loss provides the under-
writer w i t h another opportunity to review the account and to determine
whether that loss is the type the underwriter expected. Summary infor-
mation about the claim or a review of the claim file provides valuable
information about the nature of the loss and the insured's operations.
• Preparation fot renewal—As a policy's expiration date approaches, an
underwriter must determine whether any changes to the account have
occurred, and, if so, repeat the underwriting process.
• Risk control and safety inspections—A risk control and safety inspection
might have contained recommendations that were requirements for policy
issuance. A follow-up investigation could reveal that only some of the
tequirements were met.
• Premium audits—Premium audits usually lag behind a renewal policy by
several months. The audit report could disclose larger loss exposures than
originally contemplated, unacceptable operations, new products, new
operations, or financial problems.

Monitor Books of Business

Monitoring a book of business entails evaluating the quality and profitability
of all the business written for any group of policies. The evaluation should
identify specific problems for each type of insurance, which can be subdi-
vided into class of business, territory, producer, and other policy subgroups.
Additionally, the insurer is concerned that the premium volume covers fixed
costs and overhead expenses for each book of business.

Underwriters use premium and loss statistics to identify aggregate problems i n

a deteriorating book of business. Reviewing the book of business can also help
determine compliance w i t h underwriting policy and detect changes in the
type, volume, and quality of policies that may require corrective action.

Special attention is given to some books of business when they are defined by
these characteristics:

• Class of business—A poor loss ratio in a particular class of business can

indicate inadequate pricing or a disproportionate number of high-hazard
policyholders relative to the average loss exposure in the classification.
• Territories or geographic areas—Monitoring territorial underwriting
results can help the insurer to target areas for future agency appoint-
ments in profitable regions. Poor results could indicate areas from which

•
 Underwriting and Ratemaking 5.17

the insurer might withdraw or i n which the insurer might raise rates, i f
permitted by regulators.
• Producers—The producer's premium volume, policy retention, and loss
ratio are evaluated both on an overall basis and by type and class of
business. T h a t evaluation should include the balance or mix of business
desired between personal and commercial insurance and the projected
growth factor. Key considerations are the goals that the insurer and pro-
ducer established and the progress made toward achieving them.

PREMIUM DETERMINATION
One of the main activities performed by the underwriting department is pric-
ing, or determining the policy premium, an activity commonly called "rating."

A n insurance premium is a periodic payment by the insured to the insurer in

exchange for insurance coverage. "Periodic" means that the payment must be
made at certain time intervals. Each premium payment buys insurance protec-
tion for a particular time petiod, such as one year.

A l t h o u g h the terminology is different, insurance premiums are determined

in much the same way as the prices of other products. For example, i n many
grocery stores, the " u n i t price" for each item is shown on the shelf. If an
eighteen-ounce jar of peanut butter costs $2.34, the unit price is $0.13 per
ounce and the final price is $2.34- I n this case, one ounce is the unit.

In insurance, the premium (final price) is calculated by multiplying the insur-

ance rate (unit price) by the number of exposure units. Depending on the
type of coverage being rated, additional steps may be needed, such as adding
charges for optional coverages.

Insurance Rates
A n insurance rate is the " u n i t price" for insurance. Multiplying the rate by the Rate
number of exposure units determines the premium. Typically, an insurer has The price per exposure unit
a separate rate in its rate manual for each of the rating classifications it uses. for insurance coverage.
A n insurer may have hundreds of rating classifications for a particular type Rate manual
of insurance. Rating classifications are based on characteristics of the insured A resource for classifying
and the loss exposures being insured. accounts and developing
premiums for given types
The ISO Commercial Lines Manual ( C L M ) provides classification tables that of insurance; includes
contain hundreds of classifications of commercial business operations. W h e n necessary rules, factors, and
calculating the premium for commercial accounts, underwriters typically guidelines to apply those
rates.
determine the insured's business operation and then find the appropriate
rating classification in the applicable classification table. See the exhibit
"Classification Table."

•
5.18 Property and Liability Insurance Principles

Classification Table
51300 Baby Food Mfg. - In glass containers
Class Code: 51300
Premium Base: Gross Sales

10100 Bakeries
Class Code: 10100
Premium Base: Gross Sales
Note: This classification includes baking operations at the same location as the store,
if the products baked are sold principally in that store.

51315 Bakery Plants

Class Code: 51315
Premium Base: Gross Sales
Note: Risks shall be classified and rated as bakeries, if products baked are sold
principally in the insured's own retail store at the same location.

10111 Barber or Beauty Shop Supplies Distributors

Class Code: 10111
Premium Base: Gross Sales

Used with permission of Insurance Services Office, Inc., and ISO Commercial Risk Services, Inc. [0A07509]

Exposure Units
The fundamental measures of the loss exposures used i n insurance rating are
Exposure unit (unit referred to as exposure units. Insurers use standardized exposure units for
of exposure) rating most types of insurance. For example, in homeowners insurance, expo-
The unit of measure (for sure units are normally expressed as $1,000 of insured value. In the case of a
example, area, gross home insured for $400,000, the number of exposure units is 400. I n the case
receipts, payroll) used to
of a home insured for $200,000, the number of exposure units is 200. See the
determine an insurance
policy premium.
exhibit "Examples of Exposure U n i t s . "

Calculation of Premium (Rate x Exposure Units)

After the insurance rate and number of exposure units are known, calculating
the premium involves a relatively simple mathematical formula. This type of
calculation is similar to that used in pricing many products that consumers
purchase.

•
 Underwriting and Ratemaking 5.

Apply Your Knowledge

A B C Company is a new business that provides Internet marketing services to
commercial clients. A B C is applying for workers compensation insurance for
its seven employees who are classified as clerical employees. T h e manual rate
is $0.30 per $100 of payroll. ABC's annual payroll is $500,000.

Calculate the basic premium that would be charged for ABC's seven employ-
ees, ignoring any additional rating factors that might apply.

a. $300
b. $3,000
c. $1,500
d. $10,500

Feedback: c. Rate x Exposure units = Premium. $0.30 x ($500,000 * $100)

= $1,500.

UNDERWRITING MANAGEMENT
To meet its goals, an insurer must adjust its underwriting rules and standards
to respond to shifting business conditions. A n insurer's underwriting manage-
ment implements these adjustments.

The underwriting management role entails various responsibilities:

• Participating in the overall management of the insurer i n making broad

business decisions
• Arranging reinsurance, which can be either treaty reinsurance (on all eli-
gible policies) or facultative reinsurance (involving a separate transaction
for each reinsured policy)
• Delegating underwriting authority, which establishes the types of deci-
sions an underwriter can make without receiving approval from someone
at a higher level
• Developing and enforcing underwriting guidelines that reflect the insur-
er's overall underwriting objectives
• M o n i t o r i n g underwriting results to determine whether the underwriting
guidelines have had the desired effect

Participating in Insurer Management

A n insurer's senior management generally includes officers responsible for
marketing, product development, claims, finance, actuarial services, and other
functions in addition to underwriting. T h e head of an insurer's underwriting
department participates w i t h other members of the insurer's management
team i n making broad business decisions about the insurer's goals, including
annual written premium and loss ratio goals, and in devising plans to meet . .
those goals. r
5.22 Property and Liability Insurance Principles

Decisions at this level might determine what type of marketing system the
insurer uses, office locations, the emphasis that will be placed on personal and
commercial insurance, and so forth. G i v e n senior management consensus o n
the insurer's broad goals and how the insurer's capacity should be allocated,
underwriting management must decide how underwriting activities can
contribute to these goals. A n insurer's underwriting management must then
develop underwriting goals that complement or support the organization's
overall goals.

Arranging Reinsurance
One of underwriting management's responsibilities is purchasing reinsurance.
Reinsurance (sometimes referred to as "insurance for insurers") serves several
purposes, including stabilizing the insurer's loss experience, providing protec-
tion against catastrophic losses, and allowing an insurer to provide a large
amount of insurance under a single policy. Reinsurers also can provide the
insurer w i t h additional underwriting information and expertise. There are two
general types of reinsurance: treaty and facultative.

Treaty reinsurance is an arrangement i n which a reinsurer agrees to automati-

cally reinsure a portion of all eligible insurance of the primary insurer. The
treaty is a contract that defines the eligible insurance. The primary insurer is
required to reinsure—and the reinsurer must accept—all business covered by
the treaty. Policies are not selected individually. Primary insurers and rein-
surers periodically renegotiate the reinsurance tteaty. Before entering into a
treaty and agreeing on pricing, the teinsurer carefully evaluates the primary
insurer's past performance and expected future underwriting results. Because
the treaty is based on all eligible insurance written by the primary insurer, the
reinsurer is more concerned with the group of insureds as a whole than w i t h
the individual accounts that compose the group.

Conversely, facultative reinsurance is not automatic but involves a separate

transaction for each reinsured policy. T h a t is, the reinsurer evaluates each
policy it is asked to reinsure. Underwriters for the primary insurer decide
which policies to submit for reinsurance, and underwriters for the reinsurer
decide which policies to reinsure. Pricing, terms, and conditions of each
policy are individually negotiated.

Delegating Underwriting Authority

I n contrast w i t h underwriters, who deal w i t h individual applications for insur-
ance, an insurer's underwriting management focuses o n the entire group of
insureds. Underwriting management must determine how much underwriting
authority to grant to those underwriters. The authority given to an under-
writer usually reflects the underwriter's experience and responsibilities and the
types of insurance handled.

•
 Underwriting and Ratemaking 5.

W i t h some insurers, underwriting authority is highly decentralized; that is,

underwriting management delegates extensive underwriting authority to field
office personnel. Other insurers are highly centralized, w i t h many or all final
underwriting decisions made in the home office. For insurers w i t h centralized
underwriting authority, field offices serve as a point of contact where insurer
personnel gather information, accept applications, and provide policyholder
services. Many insurers are neither completely centtalized nor completely
decentralized; these insurers strive to maintain a balance between the under-
writing authority given to underwriters in field offices and the underwriting
authority reserved for home office underwriters.

Many insurers also grant some underwriting authority to the agents who rep-
resent them. These agents, known as front-line underwriters, make the initial
underwriting decision about applications and then forward those applications
that meet underwriting guidelines to the insurer's underwriter. Agents usually
have the authority to accept applications and bind coverage for the insurer
if the applicant clearly meets the guidelines and if the limit of insurance is
w i t h i n a predetermined amount. The extent of the authority granted to an
agent generally depends o n the agent's premium volume and loss experience
w i t h the insurer.

Developing and Enforcing Underwriting Guidelines

Underwriting management develops the guidelines that underwriters use i n
the underwriting process. Organization-wide rules guide underwriters toward
consistent decisions that enable the insurer to meet its overall underwrit-
ing goals. Underwriting guidelines and bulletins explain how underwriters
should approach each application. The guidelines list the factors that should
be considered by the underwriter for each type of insurance, the desirable
and undesirable charactetistics of applicants relative to those factors, and the
insurer's overall attitude toward applicants that exhibit those characteristics.
Based on the guidelines, underwriters evaluate the applications they teceive,
decide how to handle the applications, and act on those decisions.

Underwriting management extends beyond the development of underwriting

guidelines. The guidelines must be clearly communicated to all underwriters.
This may require training programs. I n addition, underwriting management
must communicate guideline revisions whenever changes arc made.

Monitoring Underwriting Results

Underwriting management must also monitor underwriting results to deter-
mine whether underwriting guidelines have produced the desired effect.
Monitoring includes steps to ensure that underwriters are following underwrit-
ing guidelines and that underwriting goals are being met. If the guidelines
are not followed, a determination of their effectiveness cannot be made.
Periodically, underwriting management sends underwriting audit teams to
visit field offices to perform an underwriting audit. If the audit reveals that

•
5.24 Property and Liability Insurance Principles

guidelines are being followed, it is then necessary to determine whether they

have produced the desired results.

For example, assume an insurer has broadened its homeowners insurance poli-
cies by adding extra coverages (such as an additional theft limit on jewelry) in
an attempt to attract new customers. M o n i t o r i n g would reveal the extent to
which insuted losses increase because of the coverage addition, whether sales
have increased, and whether revenues from the increased sales more than
offset the costs of claims.

Many factors affect an insuter's success. Constant monitoring of underwriting

results enables underwriting management to adjust underwriting guidelines to
accommodate changing conditions, goals, and results.

REGULATION OF UNDERWRITING ACTIVITIES

In the intetest of protecting the public, every state i n the United States regu-
lates insurers' underwriting activities and places some constraints on the terms
and conditions that insurers offer.

Two important examples of underwriting activity regulation are these:

• Prohibition of unfair discrimination

• Restrictions on cancellation and nonrenewal

Prohibition of Unfair Discrimination

The ability to discriminate fairly among applicants is one of the most impor-
tant elements of underwriting. However, state insurance regulations prohibit
unfait discrimination in insurance. This prohibition also applies to insurance
underwriting activities. The challenge lies in distinguishing between fair dis-
crimination and unfair discrimination.

Despite the common assumption that discrimination always has negative con-
notations (as in, for example, sexual or racial discrimination), discrimination
itself can be a neutral act. Fot example, teachets discriminate—that is, they
finely distinguish—when they assign different grades to students w i t h differ-
ent levels of performance. Schools discriminate categotically when they admit
kindergarten students based on age rather than rating them individually on
the basis of physical or mental maturity.

Similarly, underwriting entails distinguishing among properties, busi-

nesses, and people and grouping them into categoties. A n insurer's ability to
discriminate fairly is essential if insureds are to be charged a premium com-
mensurate w i t h their loss exposures. According to state insurance laws, unfair
discrimination is prohibited as an unfair trade practice. Examples of unfair
discrimination include refusing to issue, canceling, or nonrenewing cover-
age for an applicant ot an insured solely on the basis of geographic location
(sometimes known as "redlining"), gender, marital status, or race.

•
 Underwriting and Ratemaking 5.25

The examples of unfair discrimination all entail some kind of prejudice—

judging, w i t h no further information, that property i n a given area, persons
of a particular gender or marital status, or members of a certain race are likely
to have unacceptable levels of losses. Further information in each case may
indicate that the applicant or insured does not meet the insurer's underwriting
standards, regardless of address, gender, marital status, or race. Therefore, if
coverage is denied after objective underwriting criteria have been applied, it
is not likely that unfair discrimination has occurred. See the exhibit "Market
Conduct Examinations."

Market Conduct Examinations

Market conduct examinations are a process of evaluation used by state insurance
departments to determine that an insurer's practices and procedures are in compliance
with state laws and regulations and to help ensure equitable treatment of insureds and
claimants.
Such examinations focus on the business practices of insurers and producers and
are designed to monitor sales and advertising, underwriting, ratemaking, and claims
practices. For underwriting practices, a market conduct examination might analyze one
or more of these activities:
• Unfair discrimination in underwriting practices
• Improper cancellation and nonrenewal
• Failure to file rates and/or forms
• Inaccurate application of filed rating plans
• Improper classification of accounts
• Inaccurate application of account classifications
• Anticompetitive practices

[DA06837]

Restrictions on Cancellation and Nonrenewal

Most states require that an insurer provide notification to the insured w i t h i n
a specified period, such as thirty days, before a policy is to be canceled or non-
renewed. This notice is intended to give the insured an opportunity to replace
the coverage. Generally, restrictions of this kind help insurance to serve its
purpose of providing protection for policyholders. However, such restrictions
also l i m i t the speed w i t h which an underwriter can stop providing coverage
for an insured who has become undesirable.

For example, after widely publicized claims involving allegations of child

abuse caused insurers to become concerned about the legal hazards of operat-
ing daycate centers, some policies providing coverage to these centers were
canceled or nonrenewed. A t the same time, insurer capacity was severely

•
5.26 Property and Liability Insurance Principles

restricted for other reasons as well, affecting many kinds of insurance. Insurers
canceled or nonrenewed some policies in an attempt to reallocate their
available capacity. In response, several states enacted laws prohibiting insur-
ers from canceling insurance policies during the policy term and restricted
insurers' rights to nonrenew policies. Even when such noncancellation laws
had not been passed, underwriters became much more reluctant to exercise
cancellation rights to avoid adverse reaction that could have led to further
regulatory restrictions o n underwriting activities.

RATEMAKING
Many insurers have a separate department that is responsible for the devel-
opment of insurance rates, commonly called ratemaking. I n some instances,
undetwritets may be responsible for ratemaking.
Ratemaking
Ratemaking is a complex process that requires analysis of both external and
The process insurers use
internal data. Most insurers employ actuaries who perform the analyses, usu-
to calculate insurance
rates, which are a premium ally as part of a separate actuarial department.
component.
Insurance rates, the basic price of insurance for each unit of exposure, are
Actuary developed through insurance rating systems established by insutets and inde-
A person who uses pendent insurance advisory organizations. Typically, insurance rating systems
mathematical methods
are primarily based on insurers' loss costs. Insurance advisory organizations
to analyze loss data and
develop insurance rates.
develop loss cost information by using either class or individual rating meth-
odologies to analyze and categorize insureds.
Insurance rating system
The price per exposure unit In determining the final rate for a particular loss exposure, an insurer adds an
determined by adjusting allowance for expenses and profits to the basic rate that has been developed
the prospective loss costs from loss costs. T h e insurer's underwriting department then determines the
for expenses, profits, and
final premium by multiplying the final rate by the number of exposure units.
contingencies.
Loss costs
The portion of the rate that
covers projected claim
Insurance Advisory Organizations
payments and loss adjusting Insurance advisory organizations work w i t h insutets in developing insur-
expenses. ance rating systems. The largest insurance advisory organization is Insurance
Insurance advisory Services Office, Inc. (ISO), which provides analytical and decision-support
organization products and services to the property-casualty industry. The National Council
An independent corporation on Compensation Insurance ( N C C I ) is an insurance advisory organization
that works with and on that manages a database of workers compensation insurance information,
behalf of insurers that analyzes industry trends, prepares workers compensation rate recommenda-
purchase or subscribe to
tions, and assists i n developing state-specific workers compensation forms and
their services, which include
endorsements. O t h e t insutance advisory organizations that operate on a coun-
developing prospective loss
costs and standard policy trywide basis include the American Association of Insurance Services and the
forms. Surety and Fidelity Association of America.

•
 Underwriting and Ratemaking 5.27

Insurance Rating Systems

Insurance advisory organizations help develop insurance rating systems by
collecting reliable loss data that insurers use i n establishing their rates and
premiums. Insurance advisory organizations continually collect loss infor-
mation from many insurers. For example, to assist insurers in determining
an appropriate rate to charge for automobile insurance during a certain
period, insurance advisory organizations may gather data on insurers' loss
costs for automobile accidents involving certain types of vehicles during a
particular year.

Insurance rating systems combine loss data from many insurers, an approach
based o n the law of large numbers. Including losses of a large number of Law of large numbers
exposure units makes the resulting loss data more reliable than an individual A mathematical principle
insurer's loss data. stating that as the number
of similar but independent
Insurance advisory organizations then analyze the loss data to determine the exposure units increases,
average loss costs per exposure unit used i n class rating. See the exhibit "Rate the relative accuracy of
predictions about future
Development Process."
outcomes (losses) also
increases.
Loss Costs
Loss data reflect historical loss costs—costs that occurred i n the past. Insurers
often adjust data on historical loss costs i n anticipation of losses that can
be expected i n the future as a result of inflation or other measurable trends.
These prospective loss costs indicate the amount of money an insurer can
expect to pay for future claims for each exposure unit. However, it is not
enough for insurers to collect money only to pay claims. A n insurer must also
cover its expenses and allow for profits and contingencies. Therefore, each Contingencies
insurer uses loss cost information to develop its own set of rates per exposure A provision in an insurance
unit, determining how much to add to basic rates to arrive at the final rate it rate for losses that could
will charge. not be anticipated in the
loss data.
Once determined, rates are published i n an insurer's rating manual or
stored in the insurer's rating system. These rates are also filed with the state
insurance department where required. I n many cases, the state insurance
department might also reject, modify, or approve the rates that w i l l be used.

Class Rating
Insurers develop loss costs for many different lines (or types) of business and
many different groups or classes of insureds w i t h i n those lines. Many kinds
Class rating
of insurance are priced using class rating. A l l members of a class are charged
A rating approach that
the same rate for insurance, although their premiums will be different if they
uses rates reflecting the
have different numbers of exposure units. For example, a homeowner w i t h a
average probability of loss
$400,000 home will pay more for homeowners insurance than a homeowner for businesses within large
w i t h a $200,000 home. groups of similar risks;
the predominant method
The basic premise of an insurance classification and rating system is that used for rating commercial
insureds w i t h similar characteristics have similar potential loss frequency properties.

•
5.28 Property and Liability Insurance Principles

Rate Development Process

Insurance advisory
organization or
insurer gathers
historical loss costs.

I
Insurance advisory
organization or
insurer establishes
prospective loss
costs.

I
Insurer enters loss
cost data into rating
system.

I
Insurer adjusts for
expenses, profits,
and contingencies.

I
Insurer determines
final rate.

Note: After the final rate is determined, the insurer multiplies it by the number of
exposure units to determine the final premium.

[DA00467]

and severity. Even though wide variation i n actual losses may occur from one
insured to the next, aggregate losses among all members of the class should be
predictably different from the losses of all members of another class who have
different characteristics. For example, an employer w i l l pay more for workers
compensation insurance for a construction worker than for a clerical worker
because construction workers as a class are more likely to become injured or
disabled o n the job than clerical workers as a class.

W h i l e no two risks are identical, grouping them enables an insurer to take

advantage of pooling. The groupings or classes should be big enough to reflect
the law of large numbers but small enough that all members share characteris-
tics related to frequency and severity of loss.

•
 Underwriting and Ratemaking 5.29

Individual Rating
W h e n insureds cannot be readily assigned to the same class, the insured loss
exposure is rated individually. For example, an individual rate, or specific Individual rate, or
rate, might be developed for fire insurance on a large, unique factory build- specific rate
ing. T h e specific building is inspected by an underwriting professional using a A type of insurance rate
point system that adds or subtracts points for such things as type of construc- that reflects the unique
characteristics of an insured
tion (masonry, wood, and so o n ) , number and type of fire extinguishers, nature
or the insured's property.
of the occupancy, capabilities of the local fire department, and the supply
of water available at nearby hydrants. The number of points determines an
insurance rate for that particular building. The rate is applied "per $100 of
insurance" to determine the premium for fire insurance.

Sometimes it is necessary to insure an exposure for which there is no estab-

lished premium-determining system. I n such cases, the underwriter has to
rely heavily on his or her judgment, a practice that is referred to as judgment Judgment rating
rating. Judgment rating is a type of individual rating. Rating used by underwriters
to rate one-of-a-kind risks.
Judgment rating does not mean that an underwriter arbitrarily sets a rate for
a particular exposure. T h e underwriter usually has experience w i t h insur-
ance covering comparable exposures and a resulting sense of what premium
amount would be appropriate. For example, successful experience i n insuring
cross-country rail shipments of coal and iron ore might help an underwriter
to decide the premium to chatge for insuring the shipment of some other bulk
cargo.

Final Rate and Premium Determination

Final rates result from prospective loss costs that move through the rating Final rate
system and become adjusted for expenses, profits, and contingencies. The price per exposure unit
Insurance rating systems assist insurers in determining rates based o n past and determined by adjusting
expected future losses. T h e rating systems also account for other factors that the prospective loss costs
for expenses, profits, and
affect insurers' final rate determination.
contingencies.
To conduct business, insurers pay not only loss costs but also other expenses,
such as underwriting and loss adjustment expenses, and plan for profits and
contingencies. To set the final rates, they charge insureds for particular loss
exposures. Individual insurers, therefore, add an allowance for factors such as
expenses, profits, and contingencies to the basic insurance rates developed
through insurance rating systems.

After the final rate has been calculated, it is multiplied by the number of
exposure units to determine the final insurance premium.

•
5.30 Property and Liability Insurance Principles

SUMMARY
The overarching purpose of underwriting is to develop and maintain a profit-
able book of business for the insurer. To accomplish this, underwriting serves
additional purposes:

• Guarding against adverse selection

• Ensuring adequate policyholders' surplus
• Enforcing underwriting guidelines

Line underwriters are primarily responsible for making day-to-day risk selec-
tion decisions. Staff underwriters assist underwriting management w i t h
making and implementing underwriting policy.

The underwriting process is a series of steps w i t h related tasks applied to

determine what submissions w i l l be insured and for what amount of insurance,
at what price, and under what conditions. The underwriting process consists
of six decision-making steps:

• Evaluate the submission

• Develop underwriting alternatives
• Select an underwriting alternative
• Determine an appropriate premium
• Implement the underwriting decision
• M o n i t o r the underwriting decision

Insurers calculate premium by determining the insured's rate classification

from a rate manual and multiplying the rate by the number of exposure units.
Exposure units are based on the type of coverage and, for commercial insureds,
the type of business. Various factors can either increase or decrease the stan-
dard rate for a particular insured.

A n insurer's underwriting management has many responsibilities:

• Participating i n the insurer's overall management

• Arranging reinsurance
• Delegating underwriting authority
• Developing and enforcing underwriting guidelines
• M o n i t o r i n g underwriting results

In the interest of protecting the public, every state regulates insurers' under-
writing activities by prohibiting unfair discrimination. I n addition, most states
require that insurers provide notification to the insured w i t h i n a specified
period before a policy can be canceled or nonrenewed.

Insurers and independent insurance advisory organizations develop insur-

ance rates through insurance rating systems. Insurance advisory organizations
gather historical loss costs from insurers to develop prospective loss costs.
Some kinds of insurance are class rated by grouping insureds w i t h similar

•
 Underwriting and Ratemaking 5.31

characteristics into the same rating class to capture potential loss frequency
and severity of the group. W h e n an insured cannot be readily assigned to the
same class, the insured loss exposure is rated individually.

Insurers add their allowance for their expenses, profits, and contingencies to
the basic rate to arrive at the final rate they charge insureds for a particular
loss exposure. After the final rate has been calculated, it is multiplied by the
number of exposure units to determine the final insurance premium.