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1.3 Insurer Underwriting and Rate Making

The primary responsibility of an underwriter is to evaluate and select the individuals or property that an insurer is willing to insure. Underwriting plays an important role in protecting the insurer against adverse selection by identifying risks that are more likely than average to experience losses. The goal of underwriting is to accept risks whose expected losses fall within the insurer's normal and predictable range of loss experience. To maintain financial stability, underwriters seek to achieve a balanced mix of insureds across different risk classifications. If an insurer accepts too many low-risk insureds, premium income and profitability may be limited. Conversely, accepting too many high-risk insureds may result in claim payments that exceed the insurer's financial capacity.

To select acceptable risks, underwriters evaluate whether an applicant meets the insurer's underwriting standards and eligibility requirements. This process is known as determining insurability. Insurance producers often serve as field underwriters by making an initial assessment of the applicant and gathering information relevant to the underwriting process. Line underwriters and staff underwriters, who are employed by the insurance company, then review applications in greater detail, evaluate the level of risk involved, and manage the overall risk selection process for the insurer.

The underwriter evaluates the level of risk presented by an applicant and assigns the appropriate risk classification. If the insurer accepts the risk, the underwriter also determines the premium rate that will apply to the policy based on the applicant's classification and degree of risk exposure.

Underwriting Factors​

The insurance application is the primary source of information used by the insurer to evaluate an applicant and underwrite a risk. Information provided in the application becomes part of the insurance contract and is used to determine whether coverage will be issued and under what terms.

When evaluating a risk, underwriters consider several factors, including:

  • The nature and characteristics of the risk
  • Any hazards that may increase the likelihood or severity of loss
  • The applicant's prior claim history
  • Additional factors that may influence the type and level of risk being insured

Depending on the type of insurance being requested, property and casualty underwriters may evaluate additional factors when determining the acceptability and classification of a risk. These factors may include:

  • Construction — the type of materials used in the building, the building's age and location, and the condition and quality of systems such as plumbing, electrical, and heating systems
  • Occupancy — who occupies the building and the manner in which the property is used
  • Protection — safety and protective features available for the property, such as fire alarms, sprinkler systems, or security devices
  • External exposures — hazards or environmental conditions surrounding the property, such as unfenced swimming pools, nearby businesses, or environmental risks
  • Driving history — traffic violations, accidents, and other driving-related information obtained from motor vehicle reports
  • Credit-based insurance score — credit-related information obtained through consumer reports that may help predict future loss exposure; however, some states restrict or prohibit the use of credit information in underwriting decisions

Premium Assumptions​

An appropriate premium must be charged based on the level of risk presented by the applicant. Premiums are determined using the same underwriting factors considered during the risk evaluation process. After assessing the risk classification, the underwriter selects the applicable rate, which is then used to calculate the policy premium.

Example

An applicant purchases $50,000 of insurance coverage, and the insurer charges a rate of $5 for every $1,000 of coverage. Since $50,000 contains 50 units of $1,000, the premium is calculated as follows:

5 × 50 = 250

Therefore, the premium for the $50,000 insurance policy would be $250.

Because insurers cannot determine in advance the exact cost of future claims, the underwriting process is used to gather and evaluate information about applicants in order to estimate potential losses and expenses. These estimates help insurers determine whether they can responsibly assume a risk and what premium should be charged for the coverage provided.

Premium rates are considered inadequate if they are too low to cover expected claims, operating expenses, and other financial obligations. At the same time, insurance rates must not be excessive or unfairly discriminatory, meaning insurers must apply rates fairly and consistently among applicants with similar risk characteristics.

Rating Components​

Loss Cost (Pure Premium)​

The loss cost, also referred to as the pure premium, represents the estimated cost of claim payments for a specific type of risk. It reflects only the amount expected to be paid for covered losses and does not include the insurer's operating expenses, administrative costs, taxes, or profit margin.

Insurers may calculate loss costs using their own historical claims data and loss experience. However, if an insurer does not have sufficient data to accurately develop rates, it may rely on loss cost information created and published by insurance rating organizations. Examples of these organizations include Insurance Services Office (ISO) and National Council on Compensation Insurance (NCCI), which provide statistical data and rating information used throughout the insurance industry.

Expense Load​

Actuaries also take into account the expense load, which represents the total cost associated with operating the insurance company and handling claims. These expenses may include administrative costs, employee salaries, sales commissions, marketing expenses, underwriting expenses, and general overhead costs necessary to conduct the insurer's business operations.

Profit Factor​

The profit factor is an amount included in insurance rates to help ensure that the insurer remains financially profitable and capable of maintaining long-term operations. This factor also provides a financial cushion that can help offset unexpected losses, including losses resulting from fraudulent claims or higher-than-anticipated claim activity.

Rating Types and Methods​

Underwriters use a variety of rating methods to determine the appropriate rate for a specific insurance risk. Some rating methods establish a fixed rate that is used to calculate the premium for the entire policy period, while other methods allow the premium to be adjusted later based on changes in exposure, loss experience, or other relevant factors.

Judgment Rating (“A” Rating)​

Judgment rating is a rating method in which the underwriter determines the appropriate rate for a specific applicant based on professional evaluation and experience. In this process, the underwriter uses their judgment to assess the unique characteristics and exposures of the risk and establish a rate that reflects the level of risk presented.

Manual Rating (Class Rating)​

Under the manual rating method, insurance rates are listed in rating manuals developed either by the insurer or by insurance rating organizations. These manuals group policyholders into categories, or classes, based on similar risk characteristics, exposures, and loss experience. After the underwriter determines the appropriate classification for an applicant, the rate assigned to that class is applied to calculate the applicant's insurance premium.

Example

Automobile insurance commonly uses rating manuals that classify drivers according to factors affecting risk and premium rates. These manuals may include classifications based on the number of vehicles insured, the age and driving experience of operators, accident history, and other measurable factors. For instance, premiums may be higher for young or inexperienced drivers because they generally present a greater likelihood of loss. However, not all risk characteristics can be fully captured through classification tables alone. Individual driving habits and unique circumstances may vary significantly from one driver to another. As a result, underwriters may also apply judgment rating to evaluate factors that are not easily measured by standard classifications when determining the final premium for the policy.

Individual Rating​

Individual rating is a rating method in which the insurer develops a rate specifically for a single policyholder rather than relying on a large classification group of similar risks. This method is used when there are not enough comparable exposure units available to apply standard rating classifications effectively. Individual rating is most commonly used for commercial insurance and specialty risks because these types of exposures often involve unique characteristics, operations, and variables that require a customized evaluation of risk and premium.

Experience Rating (Merit Rating)​

Most insurance rates and premiums are based on estimated future losses and statistical predictions about the insured's level of risk. In contrast, merit rating determines rates by considering the insured's actual loss experience. One common form of merit rating is experience rating, which evaluates the policyholder's prior claims history over a specified period, such as the previous three years. The insurer compares the frequency and severity of the insured's losses to the loss experience of similar risks within the industry. If the insured has fewer losses than the industry average, the insurer may apply a more favorable premium rate. Conversely, if the insured has a higher-than-average claims history, the insurer may increase the premium to reflect the greater level of risk.

Rating Approval​

Insurance rates are commonly regulated by state law to ensure that they are not inadequate, excessive, or unfairly discriminatory. Regulatory requirements are designed to help protect consumers while maintaining the financial stability of insurers. The specific rate approval process an insurer must follow may vary depending on the type of insurance coverage involved and the laws of the state in which the insurer operates.

File and Use​

Under this method, insurance rates must be filed with the state insurance regulatory authority, typically the state department of insurance, and the insurer may begin using the rates immediately upon filing.

Use and File​

Under this approach, the insurance company is permitted to implement rate changes immediately. However, the insurer must submit the revised rates to the state insurance department within a specified time period established by state law or regulation.

Prior Approval​

Under this rate approval method, insurers are not permitted to use new rates until the rates have been approved by the state department of insurance or until a specified waiting period has passed following the filing of the rates with the regulatory authority.

In certain situations, an insurer may charge a premium rate that is higher than the rate normally approved by the state insurance regulatory authority. Some states permit this practice through the use of a consent-to-rate form. This form allows the insurer to apply the higher rate only if the applicant knowingly agrees to it. To authorize the higher premium, the applicant must review and sign the consent-to-rate form.

Mandatory Rates​

Some states require insurers to use mandatory rates for certain types of insurance coverage. Under this system, insurers are not permitted to alter or independently determine the rates for those specific lines of insurance. For example, flood insurance provided through the National Flood Insurance Program (NFIP) is administered under the authority of Federal Emergency Management Agency (FEMA). FEMA establishes the premium rates that must be used for NFIP flood insurance policies.

Open Competition​

Under this approach, the state relies on market competition among insurance companies to encourage the development of rates that are fair, adequate, and reasonable for consumers.

Financial Ratios​

Financial ratios are used to evaluate the financial performance and profitability of an insurance company. These measurements help insurers assess whether premium rates are producing sufficient revenue to cover claims, expenses, and profit objectives. Financial ratios may also assist insurers in determining whether rates should be increased or decreased and in evaluating the overall effectiveness and success of the company's underwriting practices.

Loss Ratio​

The loss ratio is a financial measurement used to evaluate an insurance company's profitability in relation to its claim payments. It compares the total amount paid for claims and loss adjustment expenses, such as claim investigation and settlement costs, to the insurer's earned premiums during a specific period of time. A lower loss ratio generally indicates greater profitability and stronger financial performance because a smaller portion of premium income is being used to pay claims. In contrast, a higher loss ratio may suggest that the insurer is paying out a large percentage of its premium income in losses, which could indicate a need for stricter underwriting standards or rate adjustments.

Expense Ratio​

The expense ratio measures an insurer's operating expenses in relation to its premium income. Operating expenses may include costs such as advertising, employee salaries and payroll, administrative expenses, and sales commissions. The expense ratio is calculated by dividing the insurer's total operating expenses by its net written premiums over a specific period of time. Similar to the loss ratio, a lower expense ratio generally reflects greater profitability and more efficient business operations.

Combined Ratio​

The combined ratio is a financial measurement used to evaluate an insurance company's underwriting performance and overall profitability from its insurance operations. It reflects how much of the insurer's premium income is being used to pay claims and operating expenses. The combined ratio is calculated by adding the loss ratio and the expense ratio together. In general, lower combined ratios indicate stronger underwriting results, more accurate premium pricing, and fewer unexpected or excessive claims losses.

Reserves​

Reserves are funds that insurers set aside to help maintain financial stability and ensure they are able to meet their future obligations to policyholders. By establishing reserves, insurers prepare for the payment of future claims and other financial responsibilities. One common type of reserve is a statutory reserve, which consists of funds that insurers are required by state regulators to maintain for the payment of future claims and policy benefits.

Loss reserves are estimated amounts set aside by insurers to cover future claim payments that may be owed to insureds. These reserves help insurers prepare financially for claims that have been reported or are expected to occur. Insurers may establish loss reserves using several methods. Reserves may be determined on a case-by-case basis for individual claims, based on average settlement amounts for specific types of claims, or according to expected loss ratios for a particular class of business or risk category.