Underwriting Risk Sharing and its Methods

Underwriting risk is the risk of loss borne by an underwriter. In insurance, underwriting risk may arise from an inaccurate assessment of the risks associated with writing an insurance policy or from uncontrollable factors. As a result, the insurer’s costs may significantly exceed earned premiums.

An insurance contract represents a guarantee by an insurer that it will pay for damages and losses caused by covered perils. Creating insurance policies, or underwriting typically represents the insurer’s primary source of revenue. By underwriting new insurance policies, the insurer collects premiums and invest the proceeds to generate profit.

An insurer’s profitability depends on how well it understands the risks it insures against and how well it can reduce the costs associated with managing claims. The amount an insurer charges for providing coverage is a critical aspect of the underwriting process. The premium must be sufficient to cover expected claims but must also take into account the possibility that the insurer will have to access its capital reserve, a separate interest-bearing account used to fund long-term and large-scale projects.

In the securities industry, underwriting risk usually arises if an underwriter overestimates demand for an underwritten issue or if market conditions change suddenly. In such cases, the underwriter may be required to hold part of the issue in its inventory or sell at a loss.

Determining premiums is complicated because each policyholder has a unique risk profile. Insurers will evaluate historical loss for perils, examine the risk profile of the potential policyholder, and estimate the likelihood of the policyholder to experience risk and to what level. Based on this profile, the insurer will establish a monthly premium.

If the insurer underestimates the risks associated with extending coverage, it could pay out more than it receives in premiums. Since an insurance policy is a contract, the insurer cannot claim they will not pay a claim on the basis that they miscalculated the premium.

The amount of premium that insurers charge is partially determined by how competitive a specific market is. In a competitive market composed of several insurers, each company has a reduced ability to charge higher rates because of the threat of competitors charging lower rates to secure a larger market share.

State insurance regulators attempt to limit the potential for catastrophic losses by requiring insurers to maintain sufficient capital. Regulations prevent insurers from investing premiums, which represent the insurer’s liability to policyholders, in risky or illiquid asset classes. These regulations exist because one or more insurers becoming insolvent due to an inability to pay claims, especially claims resulting from a catastrophe, such as a hurricane or a flood, can negatively impact local economies.

Underwriting risk is an integral part of the business for insurers and investment banks. While it is impossible to eliminate it entirely, underwriting risk is a fundamental focus for risk mitigation efforts. The long-term profitability of an underwriter is directly proportional to its mitigation of underwriting risk.

Risk, exclusivity, and reward

Once the underwriting agreement is struck, the underwriter bears the risk of being unable to sell the underlying securities, and the cost of holding them on its books until such time in the future that they may be favorably sold.

If the instrument is desirable, the underwriter and the securities issuer may choose to enter into an exclusivity agreement. In exchange for a higher price paid upfront to the issuer, or other favorable terms, the issuer may agree to make the underwriter the exclusive agent for the initial sale of the securities instrument. That is, even though third-party buyers might approach the issuer directly to buy, the issuer agrees to sell exclusively through the underwriter.

In summary, the securities issuer gets cash up front, access to the contacts and sales channels of the underwriter, and is insulated from the market risk of being unable to sell the securities at a good price. The underwriter gets a profit from the markup, plus the possibility of an exclusive sales agreement.

Also, if the securities are priced significantly below market price (as is often the custom), the underwriter also curries favor with powerful end customers by granting them an immediate profit (see flipping), perhaps in a quid pro quo. This practice, which is typically justified as the reward for the underwriter for taking on the market risk, is occasionally criticized as unethical, such as the allegations that Frank Quattrone acted improperly in doling out hot IPO stock during the dot-com bubble.

In an attempt to capture more of the value of their securities for themselves, issuing companies are increasingly turning to alternative vehicles for going public, such as direct listings and SPACs.

Continuous underwriting

Continuous Underwriting is the process in which the risks involved in insuring people or assets are being evaluated and analyzed on a continuous basis. It evolved from the traditional underwriting, in which the risks only get assessed before the policy is signed or renewed. Continuous underwriting was first used in Workers’ Compensation, where the premium of the insurance was updated monthly, based on the insured’s submitted payroll. It is also used in Life Insurance, as well as Cyber Insurance.

Real estate underwriting

In evaluation of a real estate loan, in addition to assessing the borrower, the property itself is scrutinized. Underwriters use the debt service coverage ratio to figure out whether the property is capable of redeeming its own value.

Forensic underwriting

Forensic underwriting is the “after-the-fact” process used by lenders to determine what went wrong with a mortgage. Forensic underwriting is a borrower’s ability to work out a modification scenario with their current lien holder, not to qualify them for a new loan or a refinance. This is typically done by an underwriter staffed with a team of people who are experienced in every aspect of the real estate field.

Sponsorship underwriting

Underwriting may also refer to financial sponsorship of a venture, and is also used as a term within public broadcasting (both public television and radio) to describe funding given by a company or organization for the operations of the service, in exchange for a mention of their product or service within the station’s programming.

The job position includes:

• Reviewing specific information to determine what the actual risk is
• Determining what kind of policy coverage or what perils the insurance company agrees to insure and under what conditions
• Possibly restricting or altering coverage by endorsement
• Looking for proactive solutions that might reduce or eliminate the risk of future insurance claims
• Possibly negotiating with your agent or broker to find ways to insure you when the issue isn’t so clear-cut or there are insurance issues.

Biometric Risks

Biometric risks refer to the risk that the company has to pay more mortality, disability or morbidity benefits than expected, or the company has to keep paying pension payments to the pension policy holders for a longer time (longevity risk) than expected when pricing the policies.

Policyholder Behavior and Expense Risks

Policyholder behaviour risks arise from the uncertainty related to behaviour of the policyholders. The policyholders have the right to cease paying premiums (lapse risk) and may have a possibility to interrupt their policies (surrender risk).

Behaviour of Policyholders is a major risk as well and ability to keep lapse and surrender rates in a low level is a crucial success factor especially for the expense result of unit-linked business.

Discount Rate Risk in Technical Provisions

Discount rate risk in technical provisions is the main risk affecting the adequacy of technical provisions. The guaranteed interest rate in policies is fixed for the whole policy period. Thus, if market interest rates and expected investment returns fall, technical provisions may have to be supplemented.

Methods

Avoidance

Avoidance is a method for mitigating risk by not participating in activities that may incur injury, sickness, or death. Smoking cigarettes is an example of one such activity because avoiding it may lessen both health and financial risks.

Life insurance companies mitigate this risk on their end by raising premiums for smokers versus nonsmokers. Health insurers are able to increase premiums based on age, geography, family size, and smoking status. The law allows for up to a 50% surcharge on premiums for smokers.

Loss Prevention and Reduction

This method of risk management attempts to minimize the loss, rather than completely eliminate it. While accepting the risk, it stays focused on keeping the loss contained and preventing it from spreading. An example of this in health insurance is preventative care.

Health insurers encourage preventative care visits, often free of co-pays, where members can receive annual checkups and physical examinations. Insurers understand that spotting potential health issues early on and administering preventative care can help minimize medical costs in the long run. Many health plans also provide discounts to gyms and health clubs as another means of prevention and reduction in order to keep members active and healthy.

Transferring

The use of health insurance is an example of transferring risk because the financial risks associated with health care are transferred from the individual to the insurer. Insurance companies assume the financial risk in exchange for a fee known as a premium and a documented contract between the insurer and individual. The contract states all the stipulations and conditions that must be met and maintained for the insurer to take on the financial responsibility of covering the risk.

Sharing

Sharing risk is often implemented through employer-based benefits that allow the company to pay a portion of insurance premiums with the employee. In essence, this shares the risk with the company and all employees participating in the insurance benefits. The understanding is that with more participants sharing the risks, the costs of premiums should shrink proportionately. Individuals may find it in their best interest to participate in sharing the risk by choosing employer health care and life insurance plans when possible.

Retention

Retention is the acknowledgment and acceptance of a risk as a given. Usually, this accepted risk is a cost to help offset larger risks down the road, such as opting to select a lower premium health insurance plan that carries a higher deductible rate. The initial risk is the cost of having to pay more out-of-pocket medical expenses if health issues arise. If the issue becomes more serious or life-threatening, then the health insurance benefits are available to cover most of the costs beyond the deductible. If the individual has no serious health issues warranting any additional medical expenses for the year, then they avoid the out-of-pocket payments, mitigating the larger risk altogether.