Essentially, financial underwriting is when an applicant has to justify to the life insurance company why they are applying for that amount of coverage. It often goes overlooked but it a critical consideration, especially for larger cases and some business situations.
Life insurance companies have become sensitive to the over-insurance problem – a situation where someone is insured for more than an insurable interest.
When someone applies for a large amount of life insurance, there is reason why. Financial underwriting seeks to find out why, and to ensure that amount of coverage can be justified.
Therefore, the amount of coverage bears a definite relationship to the applicant’s net worth and income.
The underwriter needs to know the purpose of the coverage applied for, which helps them determine if the beneficiary’s economic loss – in the event of the insured person’s death – is in line with the total amount of insurance in-force.
Other factors considered during the financial underwriting process are a growth rate and duration variable.
Forecasting the future value of financial assets is guesswork, and there is no reliable way to predict the future. However, underwriters are trained to take future values into consideration. Future values are today’s values plus compound interest and/or growth in value over time, to a specific point in the future.
It is calculated by using an assumed interest rate or rate of appreciation during the desired time horizon.
While medical underwriting is more art than science, the opposite is true of financial underwriting. Many tools and techniques have been developed over the years, such as income multiples, capitalization formulas, and the future-value approach.
The underwriter is looking for evidence of anti-selection (i.e., where the risks are not evened out), which is also known as “selection against the company”. Meaning, the applicant and/or intended beneficiary is especially claims-conscious and thereby more likely to anticipate a death claim than the average insured risk.
To help minimize the impact of financial anti-selection, underwriters commonly apply four tests:
1. Vulnerability – Is insurance the best method for protecting the financial objective?
2. Attainability – Is the forecasted asset or value growth realistic?
3. Normalcy – Is the financial objective normal or speculative?
4. Desirability – How strongly motivated is the applicant to achieve the state objective?
The risks considered during the financial underwriting process include:
· Inflation, which reduces purchasing power over time
· Family or partnership situations – divorce or the possible breakup of a business partnership
· Financial uncertainty – e.g., job loss, disability, or reduction of future profits/earnings
· Tax law changes, which affect future projections
· Market risks, which affect future values
· Interest rate changes, which affect asset valuations