Financial Justification in Life Insurance Underwriting

The principle of insurable interest is of great philosophical and moral significance but would be of little practical value without some means to measure it. The process of financial underwriting is the means by which the theoretical concept of insurable interest is applied in real-world situations.

The basic purpose of financial underwriting is to determine if the insurance need can justify the amount of insurance. If the amount applied for is in excess of the amount of the potential economic loss, then poor persistency or adverse selection may occur; it suggests potential moral hazard. The term “moral hazard” refers to the intention of the proposer.

If the insurance proposal is made with an intention to seek undue advantage from the policy, then there is some moral hazard.

Underwriters have to judge the existence of moral hazard through secondary factors such as lifestyles, income as compared to the premium payable, reputation for integrity, present financial condition, etc. If they suspect moral hazard, then the insurer usually will decline the proposal.

One of the indicators of moral hazard is the amount of insurance proposed compared to the income of the applicant. The extent of the insurable interest of a person in his own life is usually assumed to be unlimited. Generally, the level of coverage is not necessarily limited to his current levels of income, because the insurer gives applicant-insureds the benefit of the doubt and assumes that these levels of income can go up some reasonable degree in the near future.

However, although dreams may become reality in the turn of a day (a pauper may go on to win a million-dollar lottery, and a struggling actor may become an overnight sensation) such projections may not be valid while making an application for a life insurance policy. This is because the applicant will have to pay insurance premiums out of present income, and a person’s worth is calculated by his present income; and not by what he thinks he may earn a decade later.

Therefore, underwriters need to check the source of income. If the applicant is not paying (or does not have adequate resources to pay) the premiums and someone else pays or will have to be paying on his behalf, then there could be issues of insurable interest and wager (betting). Even if the underwriters can reasonably rule out moral hazard, other factors enter into an insurer’s decision to accept an application, for insurance. If the premium paid is large compared to the income, the possibility of lapse is very high. Other possibilities include higher claims, money laundering and fraud.

Making a judgment on all these factors is what the insurance industry calls financial underwriting. When all is said and done, the question financial underwriters need to answer is: “Does the proposal make sense?”

In summary, financial underwriting is an area of underwriting which aims to determine, first, if the applicant has a legitimate insurable interest in the life being insured and, second, whether the amount being applied for is consistent with that insurable interest, the level of the applicant’s insurance need, and the financial capacity of the applicant to pay required premiums. In this process, the financial underwriters are trying to ensure that there is no question of over-insurance, or speculation or possibility of fraud arising out of pure monetary considerations. If there is evidence of over-insurance or fraud, there exists moral hazard, and there is only one decision in such cases; to decline the proposal.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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