What is Cash Flow Underwriting
Insurance companies may use cash flow underwriting as a pricing strategy when they price an insurance product below the rate of premium required to assume the cost of expected losses. The purpose of this strategy is to generate substantial investment capital from the increased business which comes from the lower pricing. Cash flow underwriting is a risky pricing strategy.
BREAKING DOWN Cash Flow Underwriting
Cash flow underwriting is a more common tactic in a soft market when a weak economy makes potential insurance customers price sensitive. To stand out from the market competition an insurance company may lower their premiums. However, at a particular point, the premium will no longer cover the anticipated risk of underwriting the policy.
For example, a homeowner with a home that has outdated plumbing and wiring wishes to get homeowners coverage. The house is at an increased risk of fire or water damage. Usually, all things being equal, the annual premium for such a structure would be higher than an equivalent home with updated systems. However, in a highly competitive market, it might make sense for an insurer to charge a smaller premium and take the higher risk, rather than lose the customer to a competitor.
Gambling with Loss Ratio in Cash Flow Underwriting
An insurer who partakes in cash flow underwriting is betting that the losses incurred from the high number of policies they write will be slow in materializing. Insurance companies set aside a reserve to cover liabilities from claims made on policies that they underwrite. The basis of the reserves is on a forecast of the loss an insurer may face over a period. The reserves could be adequate or may fall short of covering its liabilities.
Losses incurred to premiums earned is known as the loss ratio, a key statistic for assessing the health and profitability of an insurance company. If a company pays $80 in claims for every $160 in collected premiums, the loss ratio is 50%.
In essence, the insurer is going for customer quantity over customer quality. Instead of fewer, higher premiums which offer a safer risk, the company bets on many lower-priced premiums at higher risk. It will then invest the increased cash flow in securities which pay higher rates of return (ROR).
The gamble is that the higher investment returns will make up for the difference in pricing, and presumably cover the inevitable claims which are the result of the higher risk. The hope is to generate capital quickly in a market where short-term interest rates are rising.
While insurance customers deal with insurance brokers and agents, the insurance company’s underwriters work behind the scenes. They are specialists in evaluating the risk of any potential policy the company may sell, and thus the premium paid. Some risks are actuarial, meaning based on statistics and demographics. For example, underwriters know that a 21-year-old single man is statistically more likely to have a car accident than a 34-year-old married woman. His car insurance will cost more. On the other hand, the older woman is more likely to become pregnant, develop breast cancer, or experience other ailments. As a result, her health insurance will cost more.