What is Underwriting Capacity
Underwriting capacity is the maximum liability that an insurance company is willing to assume from its underwriting activities. Underwriting capacity represents an insurer’s ability to retain risk.
BREAKING DOWN Underwriting Capacity
An insurance company’s potential for profitability depends on its appetite for risk. The more risk it assumes by underwriting new insurance policies, the more premiums it collects and later invests. When an insurer accepts additional hazards, through the issuance of policies, the possibility increases that it may become insolvent. A company's underwriting capacity, or the maximum amount of acceptable risk, is a crucial component of its operations.
To protect policyholders, regulators prohibit insurance companies from underwriting an unlimited number of policies.
How Insurers Increase Underwriting Capacity
Over time, an insurer’s underwriting capacity can change based on how the factors used to calculate its capacity change. An insurance company can increase its underwriting capacity by underwriting policies that cover less volatile risks. As an example, a company may refuse to write new property insurance coverage in a hurricane-prone zone, but will still cover hazards from fire and theft. Limiting the risk of policies written reduces the likelihood that the company will have to pay out claims.
Insurers are also able to increase underwriting capacity by ceding their obligations to a third party, as with 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 paid by the policyholder. The liabilities assumed by the reinsurer no longer count against the ceding company's underwriting capacity, which allows the insurer to underwrite new policies.
Using reinsurance does not mean that the insurer can abandon the liabilities it cedes in the reinsurance contract. The ceding company is still ultimately responsible if a claim should occur. In a situation where the reinsurer becomes insolvent, the ceding insurer must pay for claims made against its original underwritten policies. Therefore, it is critical for the insurer to know the financial health of the reinsurer, including the amount of risk that the reinsurer has agreed to take on through other reinsurance contracts.