In the insurance industry, the practice of underwriting refers to the process of accepting or rejecting risks. It is the very heart of insurance and is the first step taken by an insurance company to generate premiums. Originally, insurance and underwriting were synonymous. That is, underwriting referred to the operation of the insurance business. As the insurance industry developed, underwriting took on a more specialized meaning.
In the early days insurance was more personal than it is today. A contract was drawn up between a property owner and a second party, who was willing to insure the specified property, or between the insured and the insurer. The contract specified the terms under which the property would be insured. The property owner placed his name at the top of the contract, stating that he was the owner of the property and beneficiary of the contract if the property was subsequently damaged. The other party, who guaranteed the contract and was the insurer, signed his name below, at the bottom of the contract. Literally, he "underwrote" the contract.
An underwriter is the person who decides whether or not to insure risks for which applications have been submitted. The underwriter's task is to evaluate a risk, estimate the potential exposure, determine the likelihood of loss, then make a decision whether or not to accept the application for insurance.
The term "underwriter" developed in the early days of marine insurance. It was common practice for individuals seeking insurance for a ship and its cargo to meet with those desiring to write such insurance in coffeehouses. A person seeking insurance for his ship and its cargo would bring a paper describing the ship, its contents, crew, and destination to the coffeehouse. The paper would circulate, with each individual who wished to assume some of the obligation signing his name at the bottom and indicating how much exposure he was willing to assume. An agreed-upon rate and terms were also included in the paper. Since these people signed their named under the description of the risk, they became known as underwriters.
As insurers changed from individual to companies, signatures on insurance contracts became those of company officers. The term underwriter continued to be used in a more restrictive sense; it applied only to the person who performed the process of selecting risks and determining the terms of insurance. Risk selection and determination of policy terms continue to be the basic duties of underwriters today.
Underwriters work for insurance companies. In addition to on-the-job training, they may earn an Associate in Underwriting designation from the Insurance Institute of America. In the life insurance segment, underwriters may enter a program of study that leads to the designation of Chartered Life Underwriter (CLU). Most CLU's are engaged in some aspect of insurance sales as well. In the property and casualty insurance segment, underwriters may work toward the designation of Chartered Property Casualty Underwriter (CPCU).
The process of underwriting involves four basic functions: 1) selection of risks, 2) classification and rating, 3) policy forms, and 4) retention and reinsurance. By performing these four functions the underwriter increases the possibility of securing a safe and profitable distribution of risks.
In this step the underwriter decides whether or not to accept a particular risk. It involves securing factual information from the applicant, evaluating that information, and deciding on a course of action. The underwriter is typically aided by a list of acceptable and prohibited risks.
Once the risk has been accepted, the underwriter then classifies and rates the policy. Several tentative classifications are usually assigned before a final decision on classifying the risk is reached. The purpose of using classifications is to separate risks into homogeneous groups to which rates can be assigned. Insurers may have their own classification and rating system, or they may obtain a system from a rating bureau.
After determining the acceptability of an applicant and assigning the proper classification and rating, the underwriter is ready to issue an insurance policy. The underwriter must be familiar with the different types of policies available as well as be able to modify the form to fit the needs of the applicant.
The first three underwriting functions—risk selection, classification and rating, and policy selection—are interdependent. That is, the underwriter determines that a certain risk is acceptable when specified rates and forms are used. The underwriter also performs a fourth separate function on every risk before the underwriting is complete: reinsurance.
Reinsurance involves protecting the insurance company against a certain portion of potential losses. Every risk presents the possibility of loss that will equal or exceed the policy limits. It is up to the underwriter to protect his or her company from undue financial strain. The underwriter does this by retaining only a certain portion of the risk and securing reinsurance for the remainder of the risk.
[ David P. Bianco ]
Dearborn Financial Institute Staff. Introduction to Life Underwriting. 11 th edition. Chicago: Dearborn Financial Publishing, 1998.
Morgan, Joseph F. Underwriting Commercial Property. 2nd ed. Malvern, PA: Insurance Institute of America, 1997.
Randall, Everett. Introduction to Underwriting. 2nd ed. Malvern, PA: Insurance Institute of America, 1994.