The Nature of Underwriting
Before the insurance claims adjuster begins a claims investigation he or she must understand the nature of underwriting because it is how an insurance policy comes into existence.
Underwriting is defined as the process of accepting or rejecting risks. It requires a determination by the underwriter of the risks for which insurance is sought and the terms under which the insurance will be written if the risk is acceptable. Underwriting insurance is a function unique to the insurance industry which transfers the risk of loss from the person or entity insured to the insurer.
Three centuries ago, insurance originally was a very personal matter. A property owner would discuss with an individual insurer the problems, values and risks of loss involved in a commercial enterprise. They would then agree upon the terms under which the insurer would insure the risk. Together they would draft a contract and the insurer would sign his name at the bottom — he literally underwrote the insurance.
When the Lloyd’s insurance marketplace started in Edward Lloyd’s coffee shop policies were often written in chalk on a blackboard and those who wished to join in the insurance would sign their name and the percentage they wished to take of the risk under the terms of the policy written on the board.
In its original usage, underwriting referred to the operation of the insurance business. Today, in application, there is a more restricted meaning applied to the term.
Underwriting, in modern usage, is a systematic technique for evaluating risks that are offered to an insurer by prospective insureds. The function of underwriting involves evaluating, selecting, classifying, and rating each risk. Underwriting establishes the standards of coverage and amount of protection to be offered to each acceptable risk. It formulates and administers the rules and procedures that are used to ensure that predetermined standards are met by underwriters. Underwriters are the risk takers. Adjusters only become involved when the risk becomes a loss and the adjuster is called upon to keep the promises made by the policy created by the underwriter.
In the US underwriting has become more corporate and less individual. Underwriters are now invariably employees of insurance companies and no longer put their personal fortunes at risk.
The process of underwriting involves four basic functions:
- selection of risks;
- classification and rating;
- policy forms; and
- retention and reinsurance.
By performing these four functions, the underwriter increases the possibility of securing a safe and profitable distribution of risks so that the insurer can profit from the insurance risks accepted by the underwriter.
Adjusters are the representatives of the insurers who fulfill the promises made by the underwriter when the risk was taken. They must determine that the decision to insure was based upon accurate facts and that the underwriter fully understood the risk he or she was taking. Underwriters, believing that the applicant reports facts to the underwriter honestly and in good faith, weigh the hazards faced by a particular property before agreeing to take on the risk of loss.
Underwriters take information from the adjusters, after a loss, to reevaluate the risk decision, to be certain they were not deceived and to better evaluate the risk taken so they can deal with future requests for renewal or increases in coverages.
Sometimes an insurer will ask the adjuster to perform a pre-risk inspection to determine if the risk is worthy before the underwriter makes the decision to accept a risk for insurance. Usually, however, information from the adjuster is provided to help the underwriter determine whether to cancel, non-renew, or continue on the risk, or modify the policy and premium before agreeing to continue on the risk.
If the adjuster develops facts, during the claims investigation, that the underwriter was deceived when the risk was accepted grounds may exist for the underwriter to make the decision in conjunction with the claims department that the policy should be rescinded or declared void. With the assistance of the underwriter who can establish facts misrepresented or concealed were material, the claims person will then seek the advice and counsel of a competent insurance coverage attorney before deciding how to deal with a claim when the policy was obtained by deception.
With knowledge of underwriting and the decision-making process used by underwriters the adjuster can properly conduct the thorough investigation required by law. Without an understanding of the factors weighed by the underwriter the adjuster does not know what questions to ask when conducting the claims investigation.
Some of the most important factors considered by the underwriter before accepting or rejecting a risk for insurance, with which an adjuster should be familiar, are discussed below.
The moral hazard is the increase in uncertainty caused by personal acts of individuals. These acts may contribute to the probability or severity of loss. The individual creating the problem may be the policyholder or another person. In either case the chance of loss is increased. A moral hazard may be present in every line of insurance. No underwriter can ignore it without incurring an increased risk of substantial loss. The moral hazard is very difficult to detect and therefore very dangerous to the insurer.
“Moral hazard” is the term used to denote the incentive that insurance can give an insured to increase the risky behavior covered by the insurance. [May Dept. Stores, 305 F.3d 597, Erickson-Hall Constr. Co. v. Scottsdale Ins. Co. (S.D. Cal., 2019)]
The competent underwriter, and adjuster, recognize that moral hazard describes a policyholder who deliberately causes loss by, for example:
- setting fire to his or her building or automobile;
- conspiring with thieves to steal his or her cargo-laden truck;
- making false entries in his or her accounts in order to justify a claim for nonexistent property; or
- reporting a burglary that never took place at his or her home or business.
Some underwriters think only of the intentional fraud when they use the term “moral hazard.” If an applicant reveals such a fraudulent intent, no sane underwriter would agree to insure him. It is for the adjuster to discover it and warn the underwriter against maintaining the risk in the future. However, most moral hazards are not of this deliberate type. There are many cases when the attitude of the policyholder has increased the hazard, without any thought of a deliberate act. The moral hazards described below can be controlled by an effective and knowledgeable underwriter.
In West Virginia, the Supreme Court of Appeals concluded that a fire policy provision making a policy void if the insured has other insurance was not permitted because moral hazard should not be increased without insurer’s knowledge. [Heldreth v. Federal Land Bank of Baltimore, 111 W.Va. 602, 163 S.E. 50 (1932).]
“The term ‘moral hazard’ refers to the incentive that insurance can create to intentionally commit the act insured against. Since the cost is shifted to the insurance company the person insured creates a loss to profit from the insurance. An example is the incentive to burn down one’s house if the house is insured for more than its value to the owner.” (Krueger Int’l, Inc. v. Royal Indemnity Co., 481 F.3d 993, (7th Cir.2007))
Moral hazard refers to the effect of insurance in causing the insured to relax the care he takes to safeguard his property because the loss will be borne in whole or part by the insurance company.) [Bancorpsouth, Inc. v. Fed. Ins. Co., 873 F.3d 582 (7th Cir., 2017)]
In this country, the dominant public policy underlying the rule requiring a person insured to have an insurable interest in the property is to eliminate a form of moral hazard. Insurance policies that compensate beneficiaries upon the destruction of property that the beneficiary does not have an interest in preserving, give beneficiaries an incentive to destroy the insured property. [See Ryan v. Royal Ins. Co. of Am., 916 F.2d 731, (1st Cir.1990)) One public policy imperative concerns the need to guard against intentional destruction of property — a form of fraud. (Nat’l Sec. Fire & Cas. Ins. Co. v. Brannon, 47 Ala. App. 319, 253 So.2d 777 (Civ.App.1971).]
Liability insurance policies often contain an exclusion for claims brought by one insured against another insured. The exclusion serves to limit moral hazard. Without such an exclusion a policy could require the insurer to pay for the business mistakes of insured.
Parties insured under the same policy would have no disincentive to sue one another, since only the insurance company would ultimately bear the cost of the judgment. This sets up what is known to economists as a moral hazard, because the party taking the risk will not bear the costs of its wrongful or negligent behavior. The Exclusion counteracts that problem by eliminating the possibility of a third party’s subsidization of such a lawsuit. Suits in which a corporation sues its officers and directors in an effort to recoup the consequences of their business mistakes turns liability insurance into business-loss insurance which was not intended by the insurer. [Vita Food Prods., Inc. v. Navigators Ins. Co. (N.D. Ill., 2017)]
Lack of Self-Interest or Morale Hazard
There are cases where the ownership of the property is less desirable than the proceeds from insurance. One example is an outdated building situated in a business area with a high concentration of business and a shortage of parking space. The owner might receive rent from tenants but could receive more if the building was razed and the land used as a parking lot. Under such circumstances, there may be a temptation to start a fire, or at least to avoid taking steps to prevent a fire.
Similarly, the person who is unable to meet the payments on a loan and is faced with foreclosure can present a moral or morale (lack of self-interest) hazard. The property may not be saleable at a price high enough to repay the loan. The policyholder may fear a lower credit rating if foreclosure begins. When any of these conditions exist, there may be a temptation to “sell the property to the insurance company” by means of a total loss.
If one’s financial well-being would be enhanced by the loss of property rather than its preservation, there would be a temptation to destroy the property or, at least, to fail to take reasonable precautions to protect the property.
When his classic 1960 Thunderbird was stolen the owner attempted to convince a California Court that his actual cash value policy was, in fact, a valued policy. In Andrew George v. Automobile Club of Southern California et al, No. B229287 (Cal.App. Dist.2 12/12/2011) George filed a class action complaint against his automobile insurer, challenging its alleged practice of identifying a specified amount as a vehicle’s “Actual Cash Value” (in plaintiff’s case, $25,000) in the insurance policy but then refusing to pay that amount in the event of a total loss. Mr. George’s attempt is an example of why valued policies are seldom written in California.
The appellate court concluded that: “George’s allegations would render the operative provisions of the policy nonsensical. … George’s interpretation would also render meaningless the provision of the policy in which the parties agreed, in case of a total loss, to appraisal procedures for establishing the amount of loss (subject to the insurer’s liability limit). Such a procedure would be entirely unnecessary if the insurer had agreed, as George claims, to payment of $25,000 irrespective of the actual value of the car on the date of loss.”
Record of Questionable Acts
Underwriting decisions are based upon the assumption that the record of the past will continue into the future. When the underwriter looks at the character of an applicant, he or she assumes that the character will not change in the future. If an applicant shows that he or she has resorted to questionable acts in the past it is likely he or she will do so again in the future.
The most obvious example is an applicant who has had one or more questionable insurance claims. Arson-for-profit is difficult to prove and allowances are made for coincidences in order to avoid prejudging a person, but the claim may be on record as a questionable one. A record of questionable non-insurance transactions in the past should also provide a clue to the character of the applicant. The underwriter who ignores an insured’s history will likely cause the insurer to pay for the repetition of it.
Other Categories of Concern
Bankruptcy, tax evasion complaints, fraud, or a record of paying debts late should all be taken into account when the underwriter is weighing the risks of insuring an applicant. If the adjuster learns that an insured was involved in any of these questionable activities, the adjuster must, as part of the investigation, establish whether the underwriter was made aware of the facts before the insurance contract was agreed to and, if not, provide that information to the underwriter and seek the underwriter’s opinion as to what effect the true facts would have had on the decision to insure.
If the underwriter received a report of a claim from a reporting service like Equifax’ CLUE, a database of property insurance claims, the Insurance Services Office’s All Claims Database, which records all liability claims, or PILR (Property Insurance Loss Registry), a database of all property insurance claims reported to the Registry by member insurance companies.
The reports, if important to the underwriter, should require the underwriter to seek information from the insured not asked for by the application.
This article was adapted from my book, “Zalma on Insurance Claims Part 102 – Second Edition”
This the second edition of the second volume in the latest addition to Barry Zalma’s insurance claims series of books and articles is part of the most thorough, up-to-date, expert-authored insurance claims guide available today. Zalma on Insurance Claims, part 102 provides in-depth explanations, analysis, examples, and detailed discussion of: • Other Insurance Clauses; • Trigger of Coverage; • Underwriting; • Conditions, Warranties and Exclusions
The author has provided checklists, sample procedures, form letters, tables and information and references to model statutes, state statutes, administrative regulations, and requirements of insurance departments nationwide.
© 2019 – Barry Zalma
This article, and all of the blog posts on this site, digest and summarize cases published by courts of the various states and the United States. The court decisions have been modified from the actual language of the court decisions, were condensed for ease of reading, and convey the opinions of the author regarding each case.
Barry Zalma, Esq., CFE, now limits his practice to service as an insurance consultant specializing in insurance coverage, insurance claims handling, insurance bad faith and insurance fraud almost equally for insurers and policyholders. He also serves as an arbitrator or mediator for insurance related disputes. He practiced law in California for more than 44 years as an insurance coverage and claims handling lawyer and more than 50 years in the insurance business. He is available at http://www.zalma.com and firstname.lastname@example.org.
Mr. Zalma is the first recipient of the first annual Claims Magazine/ACE Legend Award.
Over the last 51 years Barry Zalma has dedicated his life to insurance, insurance claims and the need to defeat insurance fraud. He has created the following library of books and other materials to make it possible for insurers and their claims staff to become insurance claims professionals.
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