Question

Underwriting refers to the process of selecting, classifying, and pricing applicants for insurance. Explain the basic principles of underwriting. Identify the major sources of information available to underwriters. Explain the Underwriting Cycle.

Answer 1

Underwriting is a process in which the appointed person, usuallly an underwriter, assesses the risk associated with the asset or the individual to be insured. After assessing the risk associated with the asset or the insured, a premium for the insurance is decided. This is the price which the insured is suppose to give to the insurer on a regular basis.

The basic principles of underwriting are as follows:

a) Generate or maximize profit.

b) Second, It is important for the insurance company to identify individuals who can boost the company's profit with optimal risk associated with them. The premium charged should be based on this risk and it is important to assess that the probability of occurence the risk associated is not high. This is important for the firm to make itself profitable with an appropriate premium charged.

c) Third, the premium collected and income from investments should be more than the company's losses and expenses. The profits are used for distribution to policyholders and finally generating profit for the firm.

Some of the sources of information for underwriting are the

a) Application to the insured: It is the major source of information which needs to be properly reviewed by the insurer

b)Inspection Report: It is used to identify the physical existence and condition of the asset.

c) Agents's report: The agent prepares a report for the insurer which covers the information regarding the insured and the level of risk exposed.

e) Medical reports: In case of helath and life insurance, physical assessment of the insured is required.

The underwriting cycle, also known as the insurance cycle, is the full cycle of boom and bust phase that the insurance companies or the industry experiences.

To elaborate, at the beginning of the underwriting cycle, there are several insurance companies in the market and due to high competition, the insurance premiums are low and competitive. However, any potential natural disaster or a similar event that results in surge in insurance claim changes the industry scenario.

There are smaller companies that might be unable to handle surge in insurance claims and go out of business. The result is that starting from highly competitive markets, there are few survivors in the market as several insurance companies go bust.

From a simple supply-demand perspective, as companies in the industry decline and demand for insurance increases, the insurance premium trends higher. Again, from an economic perspective, as insurance premium trends higher, it attracts more companies in the industry. With the demand-supply gap again narrowing, the insurance premium begins to decline again. Any similar natural disaseter would make the cycle repeat again with smaller companies going bust.

This complete cycle of boom and bust related with higher and lower insurancweew premium coupled with higher and lower competition is referred to as the insurance cycle or underwriting cycle.