The underwriting process aims to understand the risks faced by an organisation and its management. It is undertaken by an insurer to help it decide on whether it should offer coverage, and if so, on what terms. Best described as part art, part science – it is essential for establishing an insurance contract that benefits all parties.
In this article, we will explore the underwriting process within the context of the following coverages:
- Directors and officers liability insurance
- Employment practices liability insurance
- Management liability insurance
- D&O insurance for nonprofits
You may also find that similar concepts apply to a broad range of financial lines insurances, such as professional indemnity insurance, cyber insurance, and even crime insurance to a certain extent. Keep in mind, however, that each policy is strictly interpreted according to its own terms and conditions.
Underwriting process: A definition
The underwriting process describes what an insurer must undertake to assess an organisation’s suitability for insurance. It involves reviewign of the underlying factors that contribute to the exposures faced by its mangement. By completing a thorough analysis, an insurer can make a decision about whether it should offer coverage, and if so, on what terms.
An insurer will develop an underwriting appetite as a benchmark for the types of risks it prefers to insure. When considering offering coverage to a particular organisation, an insurer will compare its characteristics against this benchmark. Over time, an insurer is also likely to compare this information with the data it has collected about all the risks it has insured over time.
An effective underwriting process aims to improve an insurer’s underwriting profit. By filtering out the undesirable risks, it can focus on insuring the organisations that take risk management seriously. This strategy ultimately benefits all parties – as the insurers will pay out less for losses that could have been avoided, an insured pays less for the coverage it requires.
The role of underwriting in a policy’s lifecycle
The underwriting process is not a one-off occurrence, and rather, it occurs throughout a policy’s lifecycle.
Application and submission
During the application process, an organisation is required to make a submission to an insurer. This will ideally include the following information:
- A proposal form
- Supporting information
- Financial statements
- Ownership structure diagram
An organisation is required to satisfy a duty of disclosure throughout this process. In practical terms, this means that it is under a strict duty to deal fully and frankly with an insurer – disclosing any material fact that is relevant to an insurer’s decision making. A failure to do so can result in severe consequences, not only for the organisation but also for individuals.
Underwriting, quoting and binding
An insurer will complete its underwriting process using the information contained within the submission. Once a quote is issued, it will typically remain valid for 30 days – subject to there being no material change to the underlying risk. If the quote is allowed to expire, the proposal form will need to be resigned and redated before coverage can be bound.
Once a policy in place, its terms will be set for the duration of the policy period. If an organisation would like to make changes to its coverage mid-term, this will need to be completed by endorsement.
Common examples of a mid-term adjustment include:
- Increasing the limit of liability
- Including an additional insured organisation
- Expanding the jurisdictional limits or territorial limits
- Amending the expiry date
- Proceeding with an extended reporting period following a change in control
An insurer may be somewhat wary of unusual requests for changes to coverage mid-term – and rightfully so. A policy’s prior acts coverage can expose an insurer to undisclosed claims if changes are not carefully considered. As a result, any alterations to the risk will need to be underwritten, and a signed no known loss letter will be required before changes are confirmed.
Expiry and replacement
As the policy period comes to an end, a replacement policy will need to be arranged. In most circumstances, an organisation will need to complete a new proposal form and provide its latest financial statements. Sometimes, a fast-track replacement process may be available – requiring less documentation. However, this is typically reserved for small and medium enterprises and nonprofit organisations.
Common underwriting considerations
An insurer will consider a number of metrics to form its initial view of an organisation’s risk.
The ownership structure of an organisation – whether it be public, private or nonprofit – provides an insurer with an insight into the type of stakeholders management is accountable to. Of all structures, publicly listed companies present the highest degree of risk, as management is carefully monitored by investors, and they are often subject to onerous compliance obligations.
An organisation’s business activities and industry often indicate the temperament of potential claimants. For example, an organisation operating in more cyclical or speculative markets, such as mining and technology, may present a higher risk than another operating in a more stable, traditional industry – such as manufacturing or wholesale.
The length of time an organisation has been operating for, as well as the relative experience of management, is an important factor during underwriting. For example, startups are often perceived to be higher risk, as they have yet to establish a track record of meeting the expectations of stakeholders, and financial feasibility more generally.
Geography of operations
The geography of an organisation’s operations plays an important role in the risks it is exposed to. An organisation operating domestically has a very different risk profile from one operating across international markets. Additionally, some jurisdictions, such as the United States and Canada, are known for having a much higher risk of litigation.
An organisation’s claims history provides an indication of its risk profile. Insurers by their nature look to acquire profitable accounts, and as a result, seek organisations with a clean history. If losses have occurred, an insurer will want to see a proactive approach to risk mitigation. Additionally, maintaining coverage with an insurer over time can help improve an organisation’s claims ratio (premium paid / claims paid).
Assessing the control environment
To gain an understanding of an organisation’s attention to risk management, an insurer will review its control environment. A control can be broadly described as a policy or process that can be implemented to reduce risk.
Common controls include:
The most significant control is not really a control per se – but rather the primary driver of an organisation’s risk – its financial position. An insurer will analyse its most recent financial statements to gain an appreciation of how well an organisation is being managed. By reviewing this information, it will be able to understand if its resources are being used efficiently.
Careful attention will be paid to operating profitability and an organisation’s ability to maintain adequate working capital – in other words, that it will be able to meet its liabilities as they become due. From an insurers perspective, an organisation will be looked upon favourably if it has strong financials and is operating in an industry with a positive economic outlook.
Recent mergers, acquisitions or corporate restructures
Mergers and acquisitions – the process of buying, selling, dividing, and combining organisations – create a unique set of risks for consideration. These types of activities are generally perceived as high risk, as most transactions will involve a range of stakeholders, each with varying interests. Should a grievance arise, management can easily be implicated.
Employee layoffs or retrenchments
Employee layoffs or retrenchments are often a sign that something is not quite right within an organisation. This relates directly to employment-related exposures, but can also be an indirect indicator that there are underlying cultural issues within an organisation more broadly. A weakening organisation that is restructuring to stay competitive, presents a higher degree of risk.
Crafting the terms of a policy
Once an insurer has reviewed an organisation’s characteristics and control environment, it will begin to craft terms. There are a number of factors to be considered.
A policy will typically insure a principal insured organisation, an additional insured organisation, and any subsidiary. When an organisation consists of a group of entities, an insurer will review the relationships between entities to decide on how best to structure coverage. An ownership structure chart will allow an insurer to better understand these relationships.
Limit of liability
A limit of liability will be offered to an organisation in an amount that is appropriate for its risk profile. Generally speaking, an insurer will not want to extend a limit of liability that exceeds an organisation’s total asset position – as not to induce any moral hazard that may arise from a policy being its largest asset. A sublimit may be applied to any exposure of a particular concern.
A self-insured retention will also be set at an amount that is appropriate for an organisaiton’s risk profile. Generally speaking, self-insured retention will be set according to its relative risk and ability to retain risk, rather than the limit of liability that has been selected. The risker an organisation, the larger the self-insured retention. This helps to protect the policy from claims, and also incentives loss mitigation.
Exclusions aim to eliminate an insurer’s exposure to undesirable claims. A policy will include standard exclusions within the wording, and specific exclusions added by endorsement.
Common examples of specific exclusions include:
- Financial impairment exclusion
- Major shareholder exclusion
- Securities offering exclusion
- Absolute exclusion (of various types)
An exclusion can be added to a policy for a variety of reasons. The risk of covering a particular loss may be too great for an insurer, or against the intention of the policy. Often, the application of an exclusion will be directly related to a weak control (identified within the proposal form), or some other undesirable aspect of risk – such as an organisation’s activities or loss history.
The effect of optional coverages
A policy will include a number of standard insuring clauses, extensions, and conditions. It may also provide an organisation with the ability to select optional coverages – either as additional insuring clauses or by endorsement.
Common optional coverages include:
Side A coverage (stand-alone)
Side A coverage is generally a standard coverage, but may also be purchased on a stand-alone basis. When done so, it is usually intended to sit in excess of a primary policy underwritten by another insurer. Stand-alone Side A will often include a provision for difference in limit and/or difference in conditions, which is particularly useful in larger programmes.
Side C coverage
Side C coverage is a form of entity coverage, that can be purchased to protect an organisation from securities-related claims. It is most commonly selected by publicly listed companies that are concerned about the liabilities arising from offer, sale, or purchase of its shares. These activities are very high risk, largely as a result of class-action claims.
Employment practices liability insurance
Employment practices liability insurance is a form of entity coverage that can be purchase to protect an organisation from employment-related claims. A policy will naturally protect any individual from these types of claims. The inclusion of this coverage protects an organisation from its own liability in these matters.
The strategy for underwriting optional coverages will depend on how it affects the risk of a policy. If a coverage inclusion increases the risk, a premium loading and higher self-insured retention are likely to be applied. However, if the risk reduces – as it may with respect to stand-alone Side A – a premium discount may be applied.
Taking into account recent claims
An insurer is likely to pay close attention to any claim notification or claim settlement that has incurred in the past twelve months. Accordingly, an organisation and its management should be prepared to answer the following question:
“What specific steps has the insured undertaken to mitigate against a similar loss occurring in the future?”
The answer will be carefully considered by an insurer and will play a large part in determining its interest in offering terms. An insurer will be looking for indications that appropiate steps have been taken to reduce the risk of similar losses occuring again in the future. For this reason, any improvement in risk managment controls should be well documented.
How the premium is calculated
The underwriting process will culminate in determining an annual premium. An insurer will use the information provided to form an opinion on the quality of an organisation’s risk. This in turn will help it decide what premium will be suitable for accepting it into its insurance pool, while at the same time remaining competitive in a marketplace of alternatives.
The first step in this process is calculating a technical premium. This figure is derived by mathematically modeling objective information about an organisation, an insurer’s claims experience for similar risks, and its capacity for insuring such risks. Actuaries play an important role in this process, by establishing a premium that will be sustainable in the long term.
An underwriter will then make adjustments to this premium based on a subjective analysis of the risk. The specific terms of the contract will be considered before arriving at a final base premium (not including taxes). Allowances will be made for the breadth of coverage, market conditions, contunity of covearge, and also relationships to a certain extent.
Underwriting process: An example
Now that we have explored the underwriting process and the influencing factors, we can tie it all together.
An organisation wishes to purchases an insurance policy to protect its management from board of directors liability. It is seeking a policy period of twelve months, from 31 December this year to 31 December next year. Its desired limit of liability is $2 million any one loss and in the aggregate, with a self-insured retention of $25,000 for Side B coverage, defence costs inclusive.
The organisation has been operating for many years in the airline industry. Its chief executive officer completes a proposal form and submits this to his broker – along with the organisation’s most recent financial statements and an ownership structure diagram. One precautionary claim notification has been made in the past year, but no costs have been incurred.
The broker provides the submission to an insurer. Following a review of the organisation’s activities, the insurer issues a quote for an annual premium of $10,000. However, because organisation’s financial position is relatively weak, a financial impairment exclusion is applied. After a few days of consideration, coverage is bound and policy documents are issued.
The underwriting process aims to understand the risks faced by an organisation and its management. It is undertaken by an insurer to help it decide on whether it should offer coverage, and if so, on what terms. It is essential for establishing an insurance contract that benefits all parties – and can be best described as part art, part science.