What it means
In insurance, underwriting risk means that the insurer's pricing and selection of customers was wrong. It may have underestimated how often claims would happen, how large they would be, or how costs such as repairs and legal fees would rise.
The premium was fixed in advance, but the cost of claims is only known later. There are several sources.
Pricing risk arises when premiums are set too low, selection risk when the insurer attracts a worse mix of customers than it expected, and catastrophe risk when one event, such as a flood, produces many claims at once. Reserving risk is a close relative: the money set aside for known claims may prove inadequate.
In investment banking the term has a different but related meaning. An underwriter that agrees to buy a whole share issue takes the risk that the market will fall before the shares are sold to investors.
If the banks are left holding securities worth less than they paid, they bear the loss. Insurers manage underwriting risk through careful pricing, tight eligibility rules, limits and exclusions in policies, diversification across many unrelated customers and reinsurance, which means buying insurance for the insurer itself.
They also hold capital as a cushion against unexpected claims, and regulators set minimum levels. For a non-specialist, the useful idea is that underwriting is a bet priced in advance.
The more precise the information and the more evenly the risks are spread, the narrower the range of outcomes. When pricing is rushed or competitive pressure is high, the margin for error shrinks quickly.
Business buyers of insurance also have a stake. An insurer that takes on too much underwriting risk may struggle to pay claims, and a customer's cover is only as good as the insurer's financial strength, so credit ratings are worth checking.
In practice
Real-world examples.
Example
A small-business insurer offers cover to restaurants at a flat rate, not adjusting for kitchen fire safety. Claims come mostly from restaurants without proper extraction systems, and the insurer's loss ratio rises sharply because its pricing did not reflect the real risk.
Example
A bank underwrites a $400,000,000 bond issue and prices it on a Monday. Over the following days interest rates jump, investors lose appetite, and the bank has to sell the last 10% of the bonds at a discount, losing money on the deal.
Example
A life insurer sells policies to a large group of customers who are healthier than average at the start. Years later, medical advances change how long people live, and the insurer finds it has underestimated how many policies will pay out and when.
Formula
Calculation
Underwriting result = Premiums - Expected claims - Expenses
Actual underwriting result = Premiums - Actual claims - Expenses
An insurer sells 10,000 policies at $1,000 each, so premiums are 10,000 x $1,000 = $10,000,000. It expects 5% of policyholders to claim, with an average claim of $12,000, and expenses of 30% of premium.
Expected claims = 10,000 x 5% x $12,000 = 500 x $12,000 = $6,000,000
Expenses = $10,000,000 x 30% = $3,000,000
Expected result = $10,000,000 - $6,000,000 - $3,000,000 = $1,000,000 profit
Now suppose the claim rate turns out to be 6.5%. Claims = 650 x $12,000 = $7,800,000, so the actual result is $10,000,000 - $7,800,000 - $3,000,000 = -$800,000. A move of just 1.5 percentage points in the claim rate turned a $1,000,000 profit into an $800,000 loss, a swing of $1,800,000.Case study
Seen in the real world.
Northgate Mutual is an illustrative, fictional insurer that entered the market for small-warehouse cover by offering the lowest premiums in its region. It priced on the assumption that 3% of customers would claim, based on a handful of years of data from a quiet period.
The next year brought an unusually wet winter, and 7% of its warehouses made claims for water damage. Average claim size was also higher than assumed because building materials had become more expensive. The company's loss ratio went from a planned 60% to over 110%.
Northgate raised premiums, introduced a surcharge for properties without flood protection and bought reinsurance for large losses. The illustrative story shows how a pricing assumption built on thin data can be right for several years and then fail all at once.
Watch out
Common mistakes.
- Assuming underwriting risk only affects insurers, when banks that underwrite securities and lenders that underwrite loans face it too.
- Pricing from a short, calm period of history and treating it as the long-run average.
- Confusing underwriting risk with investment risk, when they are separate sources of profit and loss for an insurer.
Questions
People also ask.
How do insurers reduce underwriting risk?
They price carefully, spread risks across many customers, use exclusions and limits, and buy reinsurance for large or correlated losses.
Is underwriting risk the same as credit risk?
No, credit risk is the chance that a borrower or counterparty does not pay, while underwriting risk is the chance that the price charged for taking on risk proves too low.
Why does underwriting risk matter to a customer?
Because an insurer that misjudges risk may raise prices sharply, withdraw cover or, in the worst case, be unable to pay claims.
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