Underwriting: insurable interest, medical information, and risk classification

What underwriting is

Underwriting is the process an insurer uses to decide whether it can accept an application for life insurance and, if so, on what basis, so that the proper premium is charged. The underwriter is the person who reviews the application and decides whether the applicant is acceptable and at what premium rate.

Underwriting exists to protect the insurer, and the other policyowners, against adverse selection: the tendency of people who are worse-than-average risks to seek more insurance. Life premiums rest on three factors: mortality (expected deaths, from mortality tables), interest (expected investment earnings on premiums) and expense (the insurer's operating costs). Underwriting is how the insurer checks that a particular applicant fits the mortality assumption built into the rate it charges.

Every life application is screened for three things, in this order of logic: is there an insurable interest, what does the medical and personal information show, and which risk class does the applicant belong in?

Insurable interest

A life policy must not be a wager on someone's death. The law therefore requires an insurable interest, and defines it in two ways:

• For persons closely related by blood or by law, a substantial interest engendered by love and affection.
• For anyone else, a lawful and substantial economic interest in the continued life, health or bodily safety of the insured, as distinguished from an interest that would arise only by, or be enhanced in value by, the insured's death.

Key rules to remember:

• You always have an insurable interest in your own life. A person of lawful age may buy insurance on their own life for the benefit of anyone, and may transfer or assign that policy immediately.
• Insuring someone else is allowed only if the benefits are payable to the insured or the insured's personal representatives, or to someone who has an insurable interest in the insured at the time the contract is made. The interest need not still exist when the insured dies. An ex-spouse or a former business partner can collect. A narrow statutory exception also lets certain charitable, educational or religious not-for-profit corporations procure a policy on another person and name themselves beneficiary.
• Typical third-party interests: spouses, parents and children (love and affection); a business in a key employee; business partners in each other; a creditor in a debtor, generally limited to the amount of the debt.
• Consent. Apart from group and family insurance, a policy on a person requires that the insured, being of lawful age or competent to contract, apply for or consent in writing. Exceptions: a spouse may insure the other spouse, and a person with an insurable interest in a minor under age 14 and a half (or on whom the minor depends for support) may insure the minor, within statutory limits.
• Employers also have an insurable interest in employees and retirees who participate in an employee benefit plan, but only with written notice and the employee's written consent, plus the right to have the coverage discontinued.
• If someone without an insurable interest collects, the insured or the insured's estate may sue to recover the proceeds.
• Buying a new policy with a primary purpose of selling it to a third party, such as an investor, may be a stranger-originated life insurance (STOLI) transaction, which New York prohibits.

Medical and personal information

Underwriters build a picture of the risk from several sources:

• The application. Part 1 collects general information (identity, owner, beneficiary, amount, occupation, other insurance). Part 2 is the medical history. The applicant's answers are representations; material misstatements can lead to rescission during the contestable period.
• The producer's report. As the field underwriter, the producer records what they observed and how the sale arose, asks every question as written, and has the applicant initial any corrections.
• Medical evidence. Depending on age and amount: a paramedical or physician's exam, blood and urine tests, and an attending physician's statement (APS) from the applicant's own doctor. HIV testing requires the applicant's specific written consent.
• The Medical Information Bureau (MIB). A member-insurer database of coded impairments from past applications. It is an alert, not a basis for declining by itself.
• Consumer and inspection reports, motor vehicle records and prescription histories. Under the Fair Credit Reporting Act, when an inspection report (an investigative consumer report) is ordered, the applicant must be told in writing, no later than three days after the report is first requested, that such a report may be made and that they may ask about the nature and scope of the investigation. The applicant must also be told which agency supplied any consumer report that leads to a decline or a higher rate. The applicant has the right to learn what the agency's file contains and to dispute errors.

Risk classification

Underwriters weigh age, sex, build, health and family history, tobacco use, occupation, hazardous hobbies, aviation, foreign travel, driving record and finances (is the amount justified?). They then place the applicant in a class:

• Preferred: better than average; lowest rates, often split into tobacco and non-tobacco classes.
• Standard: fits the physical, occupational and other standards on which normal premium rates are based.
• Substandard (rated): does not meet the standard requirements. An additional premium is charged because a shorter life span is more likely. Ratings are usually table ratings (percentage extra mortality) or a flat extra per thousand.
• Declined: the risk is uninsurable at any rate.

Many insurers score risks with a numerical rating system: start at 100 (standard), add debits for unfavorable factors and subtract credits for favorable ones.