What Is Underwriting Capacity?
Underwriting capacity is the maximum amount of liability that an insurance company agrees to assume from its underwriting activities. Underwriting capacity represents an insurer’s ability to retain risk. It's important for an insurance company to calculate and maintain its underwriting capacity so it will be able to pay out claims to customers when needed so as to avoid insolvency.
- Underwriting capacity is the maximum liability that an insurance company is willing to assume from its underwriting activities.
- When an insurer accepts additional hazards through the issuance of policies, the possibility increases that it may become insolvent.
- The more risk that an insurance company assumes by underwriting new insurance policies, the more premiums it can collect and later invest.
- To protect policyholders, regulators prohibit insurance companies from underwriting an unlimited number of policies.
Understanding Underwriting Capacity
Underwriting involves assessing the degree of risk associated with offering insurance to an applicant. As the provider of the policy, the insurer will diligently seek to determine if it’s profitable to offer coverage and then, based on its research, establish a price. This price is known as the premium, and it is charged in exchange for taking on the risk of covering the applicant against loss.
Through the issuance of new policies, an insurer accepts additional hazards and increases the possibility that it may become insolvent. Though seemingly unlikely, there’s always a slight chance that too many policyholders will file claims all at once, leaving the insurer forced to make a number of large payments beyond its financial means.
At the same time, 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 can collect and later invest.
Striking the right balance is essential to maintaining and improving the financial health of the insurer. In other words, a company's underwriting capacity, or the maximum amount of acceptable risk, is a crucial component of its operations. An insurance company’s profitability hinges on the quality of its underwriting.
Underwriting Capacity Requirements
Insurers are not given free rein to choose how much risk they want to take on. To protect policyholders, regulators prohibit insurance companies from underwriting an unlimited number of policies by capping their capacity.
Often, the insurer will impose even stricter constraints on itself to stave off the threat of insolvency. Applications can be rejected outright if the risk is deemed too high, or revised with new, specific individual conditions attached.
Methods Used to Increase Underwriting Capacity
Smart underwriting practices should generate premiums that exceed losses and expenses, increasing the policyholder surplus and capacity to issue more policies. Listed below are some of the common methods used by insurers to protect themselves from paying out an excessive amount of claims and to help them build up their ability to take on more business.
An insurance company can increase its underwriting capacity by underwriting policies that cover less volatile risks. For instance, a company may refuse to write new property insurance coverage in a hurricane-prone zone, but still cover hazards from fire and theft. Limiting the risk of policies reduces the likelihood that the company will have to pay out claims.
Sharing the Load
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, enabling the insurer to underwrite new policies.
In the case of sharing the load, 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. It is, therefore, critical for the insurer to be aware of the financial health of the reinsurer, including the amount of risk that the reinsurer has agreed to take on through other reinsurance contracts.