Underwriting, Rating, and Risk Selection
Underwriting is selecting and pricing risk; rating converts exposure into premium. The exam tests the financial ratios that measure underwriting results, the rating methods used in casualty lines, and the factors that drive accept, decline, or modify decisions.
Selection and hazard
- Adverse selection occurs when a pool attracts worse-than-average risks; underwriting guidelines and pricing segmentation counter it.
- Moral hazard is conduct that changes after insurance is purchased, such as carelessness or exaggeration. Morale hazard is indifference to loss.
- Physical hazards, moral and morale hazards, exposure, and claims history drive the decision.
Ratios
- Loss ratio = incurred losses ÷ earned premium.
- Expense ratio = underwriting expenses ÷ written premium.
- Combined ratio = loss ratio + expense ratio, plus loss adjustment expense if shown separately. Below 100% indicates an underwriting profit.
- Loss costs are expected claim costs published by advisory organizations such as ISO and NCCI; insurers add expenses and profit to build rates.
Rating methods
- Class rating for homogeneous exposures, such as workers compensation classifications and auto symbols.
- Schedule rating applies debits and credits for individual characteristics.
- Experience rating compares actual losses to expected losses; a modification below 1.0 indicates better-than-average experience.
- Retrospective rating adjusts premium after the policy period based on actual losses, subject to minimum and maximum premiums.
- Premium audit adjusts premium for payroll or sales actually realized during the term.
Worked example
An insurer earns $1,000,000 in premium, incurs $600,000 in losses and $60,000 in loss adjustment expense, and has $250,000 in underwriting expenses. The loss and LAE ratio is ($600,000 + $60,000) ÷ $1,000,000 = 66%. The expense ratio is 25%. The combined ratio is 91%, an underwriting profit of 9 points before investment income.
Traps that cost marks
- Mixing written and earned premium in the loss ratio; losses are matched to earned premium.
- Confusing experience modification with schedule rating credits.
- Assuming a combined ratio below 100% guarantees an overall profit; investment income is separate.