Module 3: Risk Underwriting


After studying this module, you should be
able to:

- Understand the proposal form
- Identify the three main function of an
underwriter
- Understand what is a warranty and deductable
- Describe the role of surveyor
- Understand the maximum probable loss and
relation to reinsurance



Principles and Practices of Insurance


Introduction

It is the duty of the underwriter to decide whether to accept a risk
and if so on what terms. In this module, we look at the steps taken by
an underwriter and how he gathers information in order to reach that
decision.

Previous modules discussed the duty of utmost good faith, the
importance of material facts and explained physical and moral
hazards. In this module we refer again to these subjects, place them
into a practical context and their importance to the underwriter when
he assesses the risk.

The use of proposal forms, brokers’ slips and surveys to obtain
information are considered. Finally, we look at how an underwriter
presents a quotation.

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Principles and Practices of Insurance

3.1 - Material facts
It is the job of the underwriter to decide whether to accept a risk
for insurance and if so he must then decide the applicable terms and
conditions. In order to do this he needs all material facts.
See Module 2: Legal principles of insurance; Section 2.1 for a more

detailed discussion of Material facts.

Do you remember the definition of a material fact?
Amaterialfactisanyfactthatincreases
the risk or makes it more hazardous
than others in a similar category. It is
also any fact that has a bearing on the
morals or character of the insured or
his manager or employees

Without all material facts, the
underwriter is unable to fully assess the risks presented to him. The
importance of material facts in the insurance contract cannot be
underestimated and failure to disclose will have serious consequences.


What are the options available to an insurance company who
subsequently discovers that their insured has failed to disclose a material
fact?
The duty of disclosure applies equally to both proposer and insurers
but the duty is more onerous for the proposer who must disclose all
material facts without being asked. In practice, although this may not
be a problem for a larger commercial organisation, clearly an individual

taking out insurance for the first time cannot possibly know those facts an

underwriter would consider material and those which are immaterial.


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Principles and Practices of Insurance


Insurance companies therefore ask the appropriate questions, typically
in a proposal form to obtain those facts they consider material. The
point remains however that without full disclosure of material facts it is
not possible to accurately assess the risk. If a proposer is in any doubt
as to whether a fact is material or not the advice must be to disclose the
information.

2.1 listed types of fact that the proposer must disclose and types of
fact that he need not disclose. For ease of reference, those lists are
repeated here.
Facts requiring disclosure include:

• A full description of the subject matter of the insurance
• Any other policies covering the same risk
• Previous insurances
• Details of previous losses and insurance claims
• Any fact that increases the risk from normal.
Facts not requiring disclosure include:

• Facts of law
• Facts of public or common knowledge
• Facts that lessen the risk
• When further information has been waived.
In deciding whether a fact is material or not the type of insurance is
relevant. The age of the proposer is material for life assurance (older

person) but is not relevant to fire insurance on a building.

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Principles and Practices of Insurance


Using the above as a guide decide, giving your reasons, whether the
following facts should be disclosed or not.
Age of the proposer (Motor):
Existing medical conditions (Medical Expenses):
Installation of a new fire sprinkler system (Fire):
Age of the proposer (Fire):
Outstanding loan on a car (Motor):
Type of stock (Theft):
Distance from the nearest police station (Fire):
The proposer’s claims record (Motor):
3.2 - Physical and Moral Hazards and the use of Warranties
After gathering the material facts the underwriters’ first decision is
whether to accept the risk or not. Some types of risk, possibly because

of a particular trade or type of property or location may be unacceptable
to an individual underwriter.

If the risk is acceptable, the next decision of the underwriter will
be to decide on the terms he will offer. In making this decision the
underwriter will consider the physical, morale and moral hazards
presented by the risk.

See Module 1: Risk and Insurance; Section 1.7 for a more detailed

discussion of Moral and physical hazards.


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Principles and Practices of Insurance


Explain hazards and the difference between physical hazard, morale
hazard and moral hazard.
In deciding terms, the underwriter must ensure that the insured makes a
fair and equitable contribution to the common pool. The underwriter will
have an average rate for a particular risk, often referred to as the ‘book’
rate based on the many years experience of underwriting that particular
class of business. To this book rate, he will make adjustments to take into
consideration the good and bad features of a risk.
As an example, the fire book rate for office building is 0.1% but if a

particular building has a car parking area, with a small workshop where
the insured stores petrol. The storing of petrol is clearly hazardous for

fire insurance. To take this risk the underwriter might increase the rate,
to say 0.15%. However, if the building has adequate fire extinguishers

the underwriter might then reduce the rate, by say 10% making the net
rate 0.135%. By adjusting the rate, the underwriter makes allowances
for the bad and good features of a risk.

The underwriter, therefore, adjusts the rate of premium to recognise the
differences that an individual risk has from the standard or normal risk
for that class and consequently the contribution the insured makes to
the common pool. The terms, however, are not just the premium to be
paid. There are occasions when no amount of additional premium will
compensate for a bad risk. Another option available to the underwriter
is to impose an excess (also known as a deductible).

An excess is the first amount payable by the insured towards any claim.
The insured pays for any claim up to the specified amount of the excess
and the excess is deducted from all claims that exceed it.
If a loss is agreed at SR750.00 but there is SR100 excess then the insured
will receive SR650.00 (750-100 = 650). A loss of SR 75.00 will be borne

by the insured himself because it is below the excess.

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Principles and Practices of Insurance


A policy has an excess/deductible of SR 2,000. How much will the
policy pay for the following claims?
a) SR 500
b) SR1, 500
c) SR 2,100
d) SR10, 500
Excesses are particularly useful for eliminating small claims, which can
be administratively expensive to deal with and of course, the excess
reduces the size of all claims, even large ones.

If the underwriter decides to impose the excess as part of his terms
for accepting the insurance, this is called compulsory excess. There
are occasions, especially for personal insurances when the insured may
request an excess in return for a discount from the premium. This is
known as voluntary excess.

In trying to ensure that the insured makes a fair and equitable contribution
to the pool of premiums for the risk introduced the underwriter can
amend the premium rate and decide whether to apply an excess as part
of the terms for accepting the risk.

There is a third option - that of imposing a warranty on the insured.

The use of warranties by an underwriter is a valuable part of his
overall terms. It enables him to ensure that good features of a risk are
maintained throughout the period of a contract. It is also valuable in
controlling poor physical hazards.
The office building referred to earlier had
petrol stored in a small workshop. The
underwriter may decide he wants to limit this
hazardous feature of the risk by restricting
the amount of petrol kept on the premises.
He will do so by including the following warranty in the policy: It
is warranted that the quantity of petrol in the workshop other than in
parked vehicles shall not exceed 50 litres at any one time.


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Principles and Practices of Insurance


The insured received a discount on the rate because of his fire

extinguishers. The underwriter will want to ensure that these are working
satisfactorily and are in place throughout the insurance period. He may
therefore include the following warranty:

It is warranted that fire-extinguishing
appliances kept on the premises are
maintained in efficient working order
during the currency of this policy.

In the event that the insured breaks either
of these warranties (by exceeding 50 litres

of petrol or if the fire extinguishers are

not maintained properly) the insurance


contract itself is jeopardised.

A warranty is a condition written specifically into an individual policy

stating that:

• Either a certain state of affairs does or does not exist
Or

• That something shall or shall not be done.
The warranty when applied to insurance contracts is a condition that
goes to the heart of the contract. Insurers consider a breach extremely
serious and a breach of a warranty makes the whole contract avoidable
at insurer’s option.

A breach can reflect the attitude of the insured that ignores or breaks
rules that can lead to physical damage. Therefore, a breach could allow
insurers to avoid payment under a policy even if the breach is not
relevant to the loss suffered. If our office owner keeps too much petrol
or fails to service his fire extinguishers, his insurance contract will be in
jeopardy.
However, unless there are other factors involved most reasonable
insurance companies do not avoid paying claims when the breach has
no connection to the cause of the loss.

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Principles and Practices of Insurance


Breaching a warranty gives insurers the option to repudiate a claim and
possibly cancel the whole contract. Insurers rarely enforce the option to
cancel but why do you think the penalty for breaching a warranty can
be so severe?
The underwriter when assessing the risk wants to ensure that the
insured makes a reasonable contribution. He also needs to ensure that
any hazardous features of the risk are under control and good features
maintained. The main terms that he can use to achieve these objectives
are the premium, excess and warranties.

Far more difficult for the underwriter is the assessment of moral hazard.

In an individual risk, it is the conduct of the person insured. The dishonest
person who may make a fraudulent or exaggerated claim clearly presents
a greater moral hazard than the honest person. However, recognising

this in advance can be difficult and so can the decision whether an

exaggerated claim is dishonest or merely a negotiating tool.

In addition to the individual, social attitudes can be important. There
may be sectors of a society that, possibly because there is no personal
victim, do not regard cheating insurers as dishonest.

Morale hazard in a business organisation can be recognised by the attitude
of management and employees. Premises that are untidy, lack supervision or
where the insured ignores safety rules suggest an attitude from management
or employees that they will not respect the insurance rules.

There is an overlap between morale and physical hazard as poor morale
hazard may lead to increasing the physical hazard that can cause or
increase the size of a loss. A no smoking rule not enforced can lead

to a discarded cigarette starting a fire. Untidy premises can cause
accidents and injuries to employees or visitors. Safety rules leading to

overcrowding or machinery not guarded correctly can cause damage.
The losses are physical but all originate from the insured’s attitude and
poor morale hazard.


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Principles and Practices of Insurance


A motor proposal form indicates that the proposer has a history of
minor accidents. Could the cause of these accidents be poor morale
hazard?
3.3 - Proposal forms and broker’s slips
Offer and acceptance are essential ingredients in an insurance
contract.

The proposal form is the most usual way the offer is made by the Insured
and the insurance company obtains information about the risk. They
are usually designed in order to present the information in a convenient
and easy to understand format that can speed up the underwriter’s
work. They will provide information concerning the physical hazards
and clues as to the moral hazard.

There is a variety of proposal forms issued by all companies covering
a whole range of policies and therefore their look and appearance can
differ greatly. Questions however, usually fall into two types those that
that are general in nature, name, address etc and those that relate to
the insured risk. We shall categorise proposal forms between personal
insurance and commercial insurance.

Personal policies are those issued for individuals e.g. private car,
house, travel etc. General questions will relate to the proposer and will
include:

• Name, age, address, occupation
• Details of previous insurance policies
• Details of previous losses or claims
• Whether any other insurance company has refused to give cover
The answers to these questions will help to build up a ‘picture’ of the
proposer.

Other questions will refer specifically to the type of insurance. Examples

include:

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Principles and Practices of Insurance

Private Car

• Vehicle details
• Driving experience of proposer
• Details of other drivers
• Use of the vehicle
House Insurance

• Location of property
• Value
• Construction
Commercial policies are those issued for businesses.
General questions may include:


• Business name and postal address
• Business locations
• Exact description of trade
• Details of previous insurances
• Previous losses and claims
Examples of specific questions include:

Third Party/Liability Insurance

• Contracts entered into
• Estimated turnover or sales
• Limit required
• Details of any machinery used
Theft

• Nature of goods
• Details of locks, bolts etc
• Value of goods
• Unoccupancy times of premises
After completing the form, the insured will sign and date the form. As
part of the form, he will also be signing a declaration at the foot of the

form. The declaration is an important part of the form as it confirms

that the information supplied by the proposer is true and correct usually
to his best knowledge and belief.


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Principles and Practices of Insurance


Many proposals also contain a warning regarding the duty of disclosure.
It may be part of the declaration or more prominently included
on the form. The note contains a warning as to the importance of

disclosing all material facts, defines a material fact and suggests that

if the proposer is in any doubt as to whether a fact is material or not
he should disclose it.

Whilst the majority of insurances require the completion of a proposal,

there are times when they are not used. In larger fire risks, the details

may be so complex that it would not be possible to provide all details in a
single form. Many insurers therefore do not use them, whilst others will
always ask the insured to sign the form as it includes the declaration.

A proposer submits a proposal form with all questions properly
answered. He encloses full payment of the premium and requests that
cover starts immediately. You note that the proposer has not signed the
form. What action would you take?
Marine insurance developed at Lloyd’s of London and the practice at
Lloyd’s is not to use a proposal form but for the broker to present
details on a broker’s slip. Today, apart from small pleasure boats it is not
common practice to use proposal forms for marine insurance.

The use of the broker’s slip has grown and it is now usual for brokers to
present larger commercial business to insurers on a slip. The broker a is
full time insurance professional and is aware of the information needed
by the underwriter to prepare a quotation. The broker’s slip will contain
all the necessary details including possibly even a guide to the rate and
conditions they expect.

A simple broker’s slip for the previously mentioned office building may

look as follows:

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Principles and Practices of Insurance


Professional Insurance Brokers Ltd


Quotation Slip
Proposer ABC Property Company
Business Building Owners
Period of Insurance 12 months from 1.1.2002
Cover required Fire
Location 125 High Street, Anytown
Sum Insured SR100M
Description 5-storey office block built 1995
Occupation Rented as offices to some 10 tenants
Previous Claims None
Previous Losses None
Other Information Underground car parking for 50 cars
Includes storage area for petrol
Fire extinguishers located on each
floor
Rate Please advise
Commission Normal terms apply

If the business is accepted, insurers may choose to accept the slip and
dispense with the requirement of a proposal. When presenting the
information the broker is acting as the agent for his client.

A broker’s slip states that the insured has never suffered a previous loss.
The insurance is prepared based on the information contained in the
slip. Later the investigation of a claim reveals that the insured has had
previous claims, although he states that he advised the broker. What is
the position of:
a) The Insurance Company
b) The Insured
c) The Broker
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Principles and Practices of Insurance

3.4 - Surveys
In respect of a simple personal insurance a proposal
form may provide sufficient information to enable the
underwriter to assess the risk and make his decision as to
whether to accept the risk and if so the terms to apply.
For larger risks and where possible for the majority of
commercial insurances a survey is required.
The surveyor is often referred to as the eyes and ears of the underwriter,
he will visit the premises to be insured and complete a report to be
submitted to underwriters to assist him to assess the risk.
The reasons for requesting surveys include:

• To obtain a full description of the risk. Particularly if the proposal is
inadequate for this purpose.

• To check that the details on the proposal are correct.
• Assess the physical hazards.
• Assess the morale hazard. Looking for such features as employee
attitude, tidiness, and cleanliness.

• Recommendations on risk improvement and loss prevention.
The shape of the report will depend largely on the complexity of the
insurance. An insurance company may have pre-printed short survey
forms covering most lines of business for smaller risks. The surveyor will
simply complete this in much the same way that the insured completed
his proposal form. For larger risks, the surveyor may need to prepare
a written report. Whether it is a lengthy printed report or a short form
the information in the report will contain the following:

• A full description of the risk. This may include a plan of the premises,
photographs, type of work undertaken, details of neighbouring
buildings.

• An assessment of the level of risk, taking into account all the physical
and morale hazards.

• An opinion on the management or housekeeping at the insured’s
premises.

• Recommendations on loss prevention.
• Adequacy of the insurance requested to ensure that it is reasonable
and not too high (over insurance) or too low (underinsurance).

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Principles and Practices of Insurance


Underinsurance is a problem for insurers because it means the insured
is not contributing sufficient funds to the common pool for the risk he
is introducing. Slight over insurance is being cautious but insurers view
excessive over insurance with suspicion. Why do you think this is so?
The underwriter’s job is in three parts. We have already discussed two of

them (first whether to accept a risk and then the terms), the third aspect

is how much of the risk to retain for his account and how much to
reinsure. To help make a decision he will rely on his surveyor’s opinion

of the worst possible scenario; the maximum loss that can be suffered

from one single event.

This maximum loss from any one event is the MPL (Maximum Probable Loss)
or sometimes the EML (Estimated Maximum Loss). It is a very important

figure to enable the underwriter to complete his job and an important aspect

of the surveyor’s report is his opinion on the amount of EML.
The sum insured is insurer’s maximum liability and
they can never pay more than this amount but the
EML may be lower than this. If for example, the

insured owns two buildings each insured for SR1M

then the total sum insured and insurer’s maximum

liability is SR2M. However, if the two buildings

are in separate locations, insurers cannot suffer a

total loss on this policy from one event: a single fire

cannot destroy both buildings. The surveyor may

estimate the EML at SR1M. The underwriter will decide his retention
based on the EML of SR1M and not the total sum insured of SR2M.

TheEMLisimportantindecidingthereinsurance
arrangements. If the surveyor estimates the
EML too high then the insurers will retain less
risk than warranted and reinsure the balance thus
paying more towards reinsurance premiums. If
he estimates it too low then insurer will retain more than warranted i.e
expose themselves to a higher risk and possibly a claim in excess of their
capacity though reinsurance outgo will be less.


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Principles and Practices of Insurance


An insured owns a building valued and insured for SR10M. He advises
that he has purchased the neighbouring building that is identical. He
adds the second building to his policy making two buildings each
insured for SR10M and a total sum insured on the policy of SR20M.
How do you think this will affect the rate? Will it:
a) Increase
b) Decrease
c) Stay the same
Give reasons for your answer
An underwriter’s job is in three parts. What are they?
3.5 - Quotations
On receipt of all the facts, an underwriter is in a position to assess the
risk. He will decide his terms and the next step to effecting cover is to
offer his terms to the proposer as a quotation. The proposer or his broker
may have approached several insurance companies for quotations.

The quotation by insurers is an offer that if the proposer accepts creates
a contract. It is important therefore for the underwriter to prepare his
quotation accurately, as it may be difficult to alter or correct any errors
at a later stage.
If the proposer accepts the quotation then insurance cover is in force
from the inception date required on or after the date of receipt of
premium. However, circumstances change and a quotation must be valid

for a fixed period, typically 30 days but could be less. At the end of this

time, the quotation is invalid and the underwriter has the opportunity
to change the terms.

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Principles and Practices of Insurance


What could the consequences be if an insurance company issued a
quotation with no date and no time limit?
It must be emphasised that there is no cover in force during the period
of the quotation. This is simply the time allowed for the proposer to
decide whether to accept the underwriter’s quotation.

If the quotation is acceptable, cover will be in force from the required
date and insurers will make steps to issue a policy. This may take several
days but cover is in force during this period. The policy is the written

evidence of the contract; it is not the contract and is not a prerequisite

for insurance.

If the insured requires evidence of the insurance, perhaps for a
contractor, bank or employee then insurers issue a cover note. This is

a document confirming that cover is in force. It may be a simple letter

from insurers or a more formal document. Once the policy is prepared
and issued, the cover note is no longer necessary.

To prepare the quotation accurately would require a completed proposal
form and a survey but for commercial reasons insurers may need to
prepare quotations before these are completed. The underwriter will
prepare the quotation but with conditions attached.
The underwriter will offer the quotation but ‘subject to completion of
a satisfactory proposal’ and if, the underwriter feels the risk requires a
survey (almost certainly for any reasonable sized commercial risk) he
will add ‘subject to completion of a satisfactory survey’.
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Principles and Practices of Insurance


A quotation for ‘office’ owners could look as follows:

New World Insurance Co Ltd
To: Professional Insurance Brokers Ltd
Date: 5th December 2001

Quotation No 1234/ABC
Proposer ABC Property Owners Ltd
Business Building Owners

Period of Insurance 12 months from 1.1.2002
Cover required Fire

Location 125 High Street, Anytown
Sum Insured SR100M
Description 5-storey office block built 1995
Occupation Rented as offices to some 10 tenants

Previous Claims None
Previous Losses None
Fire Rate .135%

Rate Subject to 1. Satisfactory Proposal Form

2. Satisfactory Survey
Warranties 1.Max 50 litres petrol (excl in parked cars)

2. Fire appliances serviced and maintained
Commission Standard

Quotation Valid for 30 days from date of issue

If the subsequent survey or proposal reveals any unsatisfactory aspects,
the underwriter has an opportunity to change his terms. If the insured
asks for immediate cover i.e. before the proposal or survey is completed,
the normal practice is to hold covered but again subject to the proposal
or survey being satisfactory.

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Principles and Practices of Insurance


An insurance company issues a quotation that the proposer accepts.
Insurers issue the policy and later the insured submits a claim. Realising
they have no proposal the company request one. On arrival, there are
several unsatisfactory features.
Do you think insurers have any grounds for refusing to consider the
claim? What should they have done?
Write your answer here.
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Principles and Practices of Insurance


Progress Check
Directions: Choose the best answer to each question.

1. If the insurance company surveys the premises this will:
a. relieve the insured of the duty of good faith
b. lower the deductable
c. lower the premium
d. none of the above
2. Which of
the following is not a material fact in relation to
comprehensive motor insurance?
a. Chassis number
b. Make and model of the vehicle
c. Value of the vehicle
d. Number of children the proposer has
3. Which of the following documents provides an underwriter with a
fast, effective and convenient method of obtaining material facts?
a. Quotation
b. Proposal Form
c. Policy
d. Certificate of insurance
4. An insurer issues a quotation on 15th January, which the insured
accepts with cover to commence on 1st February. A loss occurs on
29th January but the insured does not inform the company as the loss
happened before cover started. After paying the claim, the insurers
discover that the loss occurred before inception.
What action can insurers take?
a. No action cause they already paid
b. They can ask the insured to pay back the claim to them
c. Cancel the policy
d. None of the above
5. Why do insurers use warranties?
a. To decrease the deductable
b. To control bad hazard and maintain good ones
c. To determine the premium
d. To determine the conditions
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Principles and Practices of Insurance


6. What is the difference between a voluntary excess and a compulsory
excess?
a. Voluntary excess is chosen by the policyholder while compulsory by
the underwriter

b. Voluntary excess is chosen by the underwriter while compulsory by
policyholder

c. Compulsory excess is more than the voluntary
d. There is no difference
7. The main function of the surveyor is to:
a. Decide the premium
b. Put the warranties
c. Visit the site to be insured and report to underwriter
d. Give advices to reduce the risk
8. EML (Estimated Maximum Loss) is:
a. The maximum loss in one year
b. The maximum loss in one claim
c. Less than the sum insured
d. Greater than the sum insured
9. When does insurance cover commence?
a. During the period of the quotation
b. After paying the premium
c. After accepting the quotation
d. From inception date after accepting the quotation
085

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