The process by which the risk of the policyholder is assessed is called underwriting.
The premium and terms of the insurance contract are based on the insurer’s
assessment of the level of the risk.
Each individual or entity wishing to be insured brings a different level of risk to the
insurer; a timber house is at greater risk of fire than one made of brick, for example.
To make sure that each insured pays a fair premium, insurers use a series of rating
factors to assign the level of risk. In general, the higher the risk, the higher the
premium.The underwriting process will differ from insurer to insurer, depending — for example —
on the level of risk they are prepared to accept. Terms and conditions may be applied to
policies to further homogenise the risks by removing particular events or circumstances
under which claims would be paid. Terms and conditions are also important to help
reduce the impacts of moral hazard and adverse selection (see p8).
Risk assessment is economically efficient, as it allows the price of the insurance to
reflect the cost of providing it. While underwriting must be consistent with the law,
any restriction of the freedom of insurers to underwrite and price according to the
risks they are accepting will most likely lead to higher insurance prices and therefore
lower availability, affordability and choice for consumers. The role of regulation here
is explained in more detail later (see p16).
Does risk-based pricing have any other advantages?
Yes, risk-based pricing encourages insurers to innovate so that they can compete
more effectively both on price and on products. Developing new, or more
sophisticated, rating factors can enable insurers to offer more competitive rates, or
to offer insurance for risks that were previously uninsurable. As insurers learn more
about the diagnosis and treatment of certain illnesses, for example, cover can be
offered for diseases that were previously uninsurable. Likewise, better modelling of
flood risk can make previously uninsurable homes insurable. Risk-based pricing can
also influence positively the behaviour of individuals (see p14 on the promotion of
So what is moral hazard?
Moral hazard is the risk that the behaviour of policyholders changes once they have
entered into an insurance contract in a way that makes the risk event more likely to
happen. For example, a car owner may drive less carefully once they have insurance
that passes the risk of the car being damaged on to an insurer.
Moral hazard can result in more claims than the insurance company expected based
on its underwriting and could result in premiums increasing for all policyholders if it
is not managed effectively. This is why it is important for the terms and conditions
of insurance contracts to be tightly worded.
And what does adverse selection mean?
Adverse selection is a situation in which higher risk individuals are more likely to take
out insurance. One of the objectives of underwriting is to avoid this by identifying
relevant risk factors and setting premiums to correctly reflect the risks.
For example, if smokers and non-smokers are offered life insurance at the same price
(based on the average life expectancy for both groups), the premium will be better
value for smokers — who can be expected to have a higher than average mortality
rate — than for non-smokers. As a result, more smokers than non-smokers are likely
to take out the insurance. The insurer will then end up with a higher than average
mortality rate (and hence higher claims) than it anticipated when it was pricing the
product, which will affect its reserves or the premiums it then charges. However, by
taking smoking into account as a rating factor in the underwriting process, insurers
can offer lower life insurance premiums for non-smokers than smokers.