All You Need To Know About Life Insurance Underwriting
Every time you buy a Life Insurance policy, you are subject to a process called underwriting. Underwriting is a mechanism of classifying and selecting risks. Life Insurance is quite unlike other Financial Products in the sense that it isn’t really an “off the shelf” purchase, but rather a customized risk-transfer solution, in a manner of speaking. The Life Insurance company evaluates the particulars of each applicant individually, and accordingly takes a call on whether or not it makes financial sense for them to take on the risk. Therefore, the form that’s filled out for Life Insurance isn’t called an application form, but rather a ‘proposal form’; given that the client is proposing that the Life Insurer in question takes on the risk associated with the potential loss of his or her life.
Underwriting is a critical function in any Life Insurance business; mistakes from the underwriting team can prove very costly to them indeed. It is the underwriters who price insurance products based on risks, and take a go/no go decision on each applicant.
The underlying premise of underwriting is the fact that each individual, based on a combination of factors (smoking and drinking habits, body weight and occupation, for starters) has a certain probability of losing their life during the course of the policy. Based on this probability, the individual is assigned to a risk pool and charged a premium accordingly.
Other critical factors that contribute to the underwriting decision are the applicant’s family medical history, dangerous hobbies, and past illnesses. For instance, the life insurance application of a past Cancer patient, even in complete remission, will be classified as a substandard risk and be priced accordingly.
The process of underwriting begins with the proposer filling out the application form. Even seemingly mundane details such as age or income bracket have a bearing on the underwriting decision; for instance, the probability of dying increases with age, and an individual’s income level will help determine whether the coverage applied for is justified or not. For instance, an auto rickshaw driver earning Rs. 15,000 per month will likely not be provided a life cover of Rs. 1 crore, as his current income wouldn’t justify it.
The underwriting team is expected to apply rationality and sound judgment in looking beyond the details furnished in the application form, in order to protect the insurer from cases of adverse selection and moral hazard.
Adverse selection refers to a scenario where a risk that is insured is more likely than its overall group to experience a loss, as a result of information asymmetry between the proposer and insurer. For instance, a 30-year-old man who is secretly ill or believes he may die soon, is more likely to apply for a Life Insurance policy than other 30-year-old men. The underwriter needs to ensure that too many such substandard risks are not accepted into the pool. A tricky job indeed!
Moral hazards can best be described by the phrase “worth more dead than alive”. Life Insurers need to do their best to ensure that the act of transferring risk does not increase the probability that the insured persons will end their own life, or that another will end their life. The proposers mental state – especially depression risk - plays a key role in determining moral hazard. Underwriters also need to consider the fact that the insured’s behavior may change after transferring their risk (for instance, they may take up smoking or start engaging in life threatening adventure sports). An applicant’s financial strength plays a key role in determining the moral hazard risk associated with any applicant. Therefore, Life Insurers insist on knowing how much death benefit is already riding on you even before you apply for a policy with them, lest theirs becomes the last straw on the camel’s back! Most insurers place strict limits on the maximum times current income they will consider as incremental death benefit, keeping your existing coverage amounts in consideration.
Based on one or more of the above factors, your proposal form could come back to you with a revised quote or with a declination notice. If the quote is revised upwards, it’s your prerogative to accept it or not.
Unfortunately, most Insurance Agents in India take the process of filling out the proposal form very casually. Clients are more than happy to hand over the form filling responsibilities to their agents, mistakenly assuming that falsification of information will not have ramifications later. Claim settlement ratios for many life insurers are in the 70-80 per cent range, meaning that 20 or 30 out of every 100 death claims get declined. This usually happens because information wasn’t properly recorded at the proposal stage. Often, even families of well-intentioned insurance buyers suffer, purely due to their carelessness. It would be wise to furnish all proposal stage information carefully and accurately, filing out the form yourself. Even if you pass through the underwriting hoop by intentionally or inadvertently furnishing wrong information about yourself, the policy issues thus will likely just be a piece of paper and nothing else.
