Underwriting Capacity

DEFINITION of 'Underwriting Capacity'

The maximum liability that an insurance company is willing to take on from its underwriting activities. Underwriting capacity represents an insurer’s capacity to retain risk.

BREAKING DOWN 'Underwriting Capacity'

An insurance company’s potential for profitability is dependent on its appetite for risk. The more risk it is willing to take on by underwriting new insurance policies, the more premiums it is able to bring in and invest. Insurers are prevented from underwriting an unlimited number of policies by regulators that want to ensure that policyholders are protected. This is because the more risk that an insurer takes on, the greater the possibility that it may become insolvent. The amount of risk that an insurer is allowed to take on, i.e. its underwriting capacity, is thus a critical component of its operations.

Underwriting capacity represents an insurer’s ability to pay for its obligations. Insurance companies determine their underwriting capacity by evaluating a number of factors. These factors include the insurer’s pricing strategy, the adequacy of its reserves, the types of assets it holds, and the volatility of its risk pool. Insurers treat the underwriting capacity as a finite number that is drawn against as new policies are underwritten, similar to a line of credit.

An insurer’s underwriting capacity can change over time based on how the factors used to calculate it change. For example, an insurer can increase its underwriting capacity by underwriting policies that cover less volatile risks. This reduces the likelihood that it will have to pay out claims. The insurer may also see poor performance in its investments, which can negatively impact its surplus and thus reduce its underwriting capacity.

Insurers are also able to increase underwriting capacity by ceding their obligations to a third party. This is done through reinsurance treaties. In a reinsurance contract, the reinsurer assumes some of an insurer’s liability in exchange for a fee or a portion of the premiums that the insurer has collected. The liabilities that the reinsurer assumes no longer count against the insurer’s underwriting capacity, which allows the insurer to underwrite new policies.

Using reinsurance does not mean that the insurer can forget about the liabilities it cedes in the reinsurance contract: the insurer is still ultimately responsible for the liability. If the reinsurer becomes insolvent and cannot uphold its end of the bargain, then the insurer will have to pay for claims made against the policies that it has created. For this reason, it is critical that the insurer understand the financial health of the reinsurer, including the amount of risk that the reinsurer has agreed to take on through other reinsurance contracts.