Table of Contents
- 1 What is insurance underwriting?
- 2 The Underwriter’s Probability
- 3 Mitigation of the Effects of Undesired Results
- 4 Avoiding Potentially Debilitating Risks
- 5 Conclusion
I was an insurance underwriter before I became a retail trader1A retail trader is an individual investor who buys and sells securities for their personal account and not for another company or organization. Also known as an “individual investor” or “small investor”. – Investopedia Dictionary. Due to my experience and training, I look at the financial markets with a different perspective than the usual personal investor. Insurance underwriting is primarily risk management for financial investments and in the short time I’ve been trading full-time, I discovered that I applied much of that experience to trading. In fact, I would even hazard a guess that if it were not for my previous work experience, I would no longer be in the game. The fact that I’m still able to do this is a testament to the usefulness of underwriting. As it appears to have some benefit to trading, I am documenting a bit of the underwriting discipline and how I personally apply it to trading. This first part describes the underwriting process.
What is insurance underwriting?
What is insurance underwriting? Insurance underwriting (or underwriting of any financial instrument for that matter) is a process of evaluating risk and determining whether to accept the risk on behalf of the company for investment. What a mouthful!
Basically, an underwriter evaluates a potential account/client for riskiness per their employer’s standards of risk. If the risk tolerance is within the insurance company’s guidelines, the underwriter prepares a quote. The client receives the quote (either directly from the underwriter or through an intermediary like a broker) and decides whether they accept the proposed terms or not. If they do, the underwriter provides the promise of protection (per the terms of the insurance policy) on behalf of the insurance company. The goal is to earn the policy premium in full by the end of the year. If there is a claim that’s paid out, then the underwriter has effectively made a “loss” on the investment. Although I’ve simplified the process, there are a few key elements to underwriting that are worth highlighting.
The Underwriter’s Probability
Insurance underwriting is much like trading in that you work with the same principles of probability. As an underwriter, as soon as you receive instructions to bind2A technical term to indicate that the insurance policy is in effect. an insurance policy, the probability that an insurance claim will be incurred on the policy is 50/50. This mathematical value cannot be changed. The moment the policy has been placed into effect, there can be a claim the very next day – even the very next moment! It bears repeating that no one can predict the future – not underwriters, not traders. If this is the case even for underwriters, then what is the point of underwriting? Quite simply, the job of an underwriter isn’t about changing the real life probability but rather to mitigate the effects of the undesired result (a claim on the insurance policy) and also to avoid potentially debilitating risks – risks that could result in a policy claim. In short, underwriting is a discipline of managing risk.
Mitigation of the Effects of Undesired Results
If you cannot change the probability of a win or a loss (that is, the probability of whether the insurance policy expires with or without a claim) then what can you do? The only sure thing you can do with absolute certainty is prepare for the worst case scenario – that is, prepare for a claim and attempt to reduce the effects of such an incident. For insurance underwriters, there are five primary ways to do this. What follows is fairly technical but don’t get too hung up on it; it is the reasoning behind the action that’s important.
Deductibles and Exclusions
Whenever people need to file a claim on their insurance policy, the first thing they usually do is look to their policy documents to find out two things: the size of the deductible and whether the claim would be covered. These factors are two of the most common methods that underwriters employ to reduce the size of claims and in many cases, completely avoid the claim. For accounts that present a higher risk, underwriters might use higher deductibles and add special exclusions that restrict the conditions and scenarios under which a claim can be made. Every time a claim is successfully submitted, after the claim is paid, the client is contractually obligated to return the deductible3There is also the self-insured retention (SIR) which is an amount deducted from the claim payment unlike the deductible where the client sends the money back to the company. amount to the insurance company. This way, underwriters are able to reduce the impact of claim payouts (albeit usually only by a small amount in relation to the claim). In addition, every policy has exclusions that specify whether a claim in a particular scenario is covered by the policy. These two methods serve to reduce the number of claims and if a claim is covered, reduce its impact.
Another common method that underwriters use to reduce the effects of a potential claim is something called a co-insurance clause. For policies that contain property coverage (buildings, equipment, stock, etc.), underwriters may opt to include this item (typically shown as a percentage). The co-insurance clause does two things:
- It ensures that the property is insured to at least the value required (so if the co-insurance amount says 90% then the limit needs to be at least 90% of the actual value of the piece of property). This is enforced by applying a penalty against the client in the event of a claim (for that piece of property).
- The premium is collected for the full (or near full) value of the insured property.
Unlike the deductible, the self-insured retention (SIR), or policy exclusions, the co-insurance clause generates additional premium. Think of it this way – without the co-insurance clause, clients can opt to insure for only a portion of the actual value of the piece of property in an attempt to save money. But there is a real cost to underwriting and providing insurance. Without the full premium, rates would need to be higher in order to offset underwriting and claims costs. In addition, in an effort to cut costs, clients can place themselves in a situation where the limit is insufficient to pay for their claim. By forcing people to insure most of the value of their property, clients are protected (in a manner of speaking) from under-insuring. At the same time, underwriters are able to collect the premium to off-set the cost of underwriting and potential claims.
Limit Exposure and Depressions
This one is a little easier to explain from a property perspective. Every insurance policy has limits (the amounts that you can purchase for insurance). Every insurance company has a maximum amount of real property it can take on per account per area/region. For example, let’s say there’s a neighbourhood of 10 homes that require insurance. Each home is worth $1,000,000 in value. Let’s also say that the insurance company can only handle a max of $5,000,000 per neighbourhood. Well, obviously, the underwriter cannot provide insurance to all 10 homes at full value because 10 homes x $1,000,000 each = $10,000,000 which goes over the max of $5,000,000 limit threshold. This is one form of limit exposure – the implementation of a maximum amount that an underwriter can be exposed to within a certain area. In addition, some accounts are riskier than others. So the underwriter might decide to self-impose a restriction on the max limit exposed. That is, the underwriter depresses4reduces their max limit so that other underwriters will be aware that the particular area/region is more risky than usual. I trust I have thoroughly confused everyone. If there’s anything I’m good at, it’s confusing people. In short, what the underwriter has effectively done is restrict the amount of property risk they are directly exposed to.
Rates & Premiums
The final way an underwriter can address the effects of a potential chance of a loss is to charge appropriate rates & premium (hint: as much as the market allows him!). Underwriters follow their employer’s actuarial rating to set base rates. However, the marketplace doesn’t always allow them to charge that premium. Oftentimes, they have to discount the rates in order to get the business. If the underwriter discounts the rate too much, then they are losing money on the investment at the get-go before even accounting for potential claims. If they charge too high of a rate, they will lose the account to a competitor. The trick is to charge fair value so that the account can be kept on the books for many years without rate changes. It is also the reason why company actuaries often require a minimum base premium (that is, the underwriter is not permitted to discount below a premium threshold) to prevent underwriters from discounting too much. I often see people shop every single year to lower their insurance rates and I wonder if anyone realises just how pointless of an exercise it is. We keep digital records of every account that has come across our desks. Whenever I see an account that has been circulating in the last few years, I tend to put those at the bottom of my bottom-less pile of work. I never waste my time on such accounts unless I’m desperate for some quick premium. I know I can spend a great deal of work on analysing its risks only to never get the account or if I do, to lose it the following year. As a result, the few people who fight over these accounts are the ones who determine fair value. And trust me, fair value for them means “market rate” which is usually higher than fair value. There is something to be said about loyalty to your underwriter!
Summary of Ways an Insurance Underwriter Reduces the Impact of Loss
- Deductibles & Self-Insured Retention (SIR)
- Policy Exclusions
- Co-Insurance Clause
- Limit Exposure and Depressions
- Rates & Premiums
Avoiding Potentially Debilitating Risks
In the previous section, we looked at how insurance underwriters reduce the effect of claims. The 5 common ways described are considered real, tangible methods to employ. Why? Because you can measure it. For example, a $1,000 deductible is a $1,000 “buffer”. A $1,000,000 max property limit is a tangible sum of money. A co-insurance clause results in premium – these are hard numbers, tangible dollar amounts. Charging fair value rates and minimum premiums result in money – something that can be measured and tracked. And lastly, policy exclusions are contractual – they are legally binding and can have a real effect on whether a claim is paid out or not. As a result, all of these methods form the second line of defense. They cannot change the underwriter’s probability of success (that remains at 50/50) but when the investment goes against the underwriter, there are real and measurable bulwarks protecting the company against financial loss.
However, this isn’t the only tool in an underwriter’s toolbox. One of the most used techniques (and in this ex-underwriter’s most humble opinion, most over-emphasised) is the reduction of theoretical probability. This is the first line of defense (which is probably why it is over-emphasised).
Reducing Theoretical Probability of Loss
Most of our underwriting training is focused around this vague concept that isn’t ever really explained correctly in underwriting textbooks or by trainers. Yes, I can hear the math experts protesting already. Truth be told, the correct term should probably be experimental probability as opposed to theoretical probability. After all, a vast majority of this “tool” is based upon past claims and underwriting experience as opposed to a mathematical calculation. If we are to be technical, the 50/50 probability mentioned at the beginning of the article is the true theoretical probability from a mathematical point of view. However, I treat it as a real probability (a term which is probably going to get me into trouble with the math experts). Just so we are clear, when I speak of real probability, I am referring to real-life, to reality. Yes, mathematically speaking, 50/50 is theoretical. But in real life we can’t see the future so what is theoretical (50/50) is in fact reality. And when I speak of theoretical probability, I am referring to an imagined, vague concept that’s closer to the definition of experimental probability. But enough math. If there is any doubt as to what I mean, it should be clear that I am not using the term in a technical sense – semantic not syntactic, please.
Back to insurance underwriting… what’s so special about reducing theoretical probability? Well, insurance underwriting is about avoiding risk (or mitigating risk). Reducing theoretical probability is just a fancy lay-term to describe this type of risk avoidance. Imagine that you, as a commercial lines insurance underwriter, receive a request to provide insurance on a restaurant. Can you see this amazing restaurant in your mind? Yes? Good. Now, from a property perspective only, what can cause this restaurant to submit a claim for damages? I can think of a few: fire, theft, flooding, a car crashing into the restaurant, anything else? How about we just focus on fire? In fact, according to various unknown acturaries, restaurant kitchen grease fires is the number one cause for claims when it comes to eating establishments. As soon as you provide the insurance policy for this imaginary restaurant, you could potentially be forced to entertain a kitchen fire claim. This makes you feel uneasy, queasy even (sorry for the greasy pun). How could you safely put this restaurant on the company’s books when kitchen fires are such a huge risk?
It turns out that there is something you can do! You can’t guarantee that kitchen fires won’t break out in this particular restaurant but you can try to reduce the chance that it will happen. All you have to do is require that the restaurant owners hire a professional steam-cleaner to steam clean the kitchen once every 6 months. This way, a good deal of the grease in the restaurant can be removed on a semi-regular basis. In addition, you can require that the restaurant provide annually updated documentation confirming that they have a functioning automatic wet-chemical fire extinguishing system. And after all this is confirmed, you send an inspector over to make sure that everybody is being hones… I mean, to make sure that the steam-cleaning was performed correctly. Does this mean that this restaurant won’t ever have a kitchen fire? No, of course not. For all you know, the steam cleaner could’ve missed a spot and that spot of grease ignites and burns down the whole place. You have no idea – it can happen5Fun fact: restaurants used to use a dry-chemical extinguishing system. But after a while, people realised that once the fire was put out, it could re-ignite the grease due to the latent high temperatures. This is why wet-chemical is now used.! However, in theory, the restaurant is now less likely to experience a kitchen fire. You just reduced the theoretical probability of a kitchen fire claim for this restaurant.
There are many other ways to reduce the theoretical probability of loss in insurance underwriting – it all depends on the type of account. For some accounts, we would want to look at audited financials while for others, we need to look at ISO-certified risk management documentation. For underwriters, the more information is provided, the better they can assess the theoretical risk. But generally, the reduction of theoretical probability of loss for insurance underwriting takes the form of preventative action and screening of clients in order to avoid risk.
And there you have it! How do insurance underwriters deal with the 50/50 chance that the insurance policy they just sold will incur a claim? They try to setup conditions to reduce the opportunities for such claims to occur and if that fails, they have fall-back measures to reduce the effects of insurance claims.