Cash Flow Underwriting: Definition and Operation
What is Underwriting for Cash Flow?
When insurance firms price an insurance product lower than the rate of premium needed to absorb the cost of anticipated losses, they may be using cash flow underwriting as a pricing technique.
The goal of this approach is to use the additional business that results from the reduced prices to create a significant amount of investment cash. One dangerous pricing method is cash flow underwriting.
Comprehending Cash Flow Underwriting
In a sluggish market, when it is challenging to draw in insurance clients due to a bad economy, cash flow underwriting is more prevalent. An insurance business may reduce its premiums in order to compete. But eventually, the premium won’t be enough to cover the expected risk of insuring the policy.
For instance, a homeowner who wants homeowners insurance wants to insure a house with old wiring and plumbing. There is a higher chance of water damage or fire in the house. The yearly premium for such a building would typically be larger than that of an identical home with modernized systems, assuming all other factors remain constant. An insurer may, however, accept the greater risk and offer a lower premium in a market with intense competition.
Gambling in Cash Flow Underwriting Using the Loss Ratio
By engaging in cash flow underwriting, an insurer is placing a wager that the losses resulting from the large volume of policies it sells will not be realized right away. A reserve is set aside by insurance firms to meet policy claim liabilities. An insurer’s potential losses throughout time are forecasted to determine the amount of reserves. Its reserves could be sufficient to meet its liabilities, or they might not be.
One important metric for evaluating the health and profitability of an insurance firm is the loss ratio, which is the ratio of losses to premiums generated. The loss ratio is 50% if a business pays $80 in claims for every $160 in premiums received.
The insurer is essentially prioritizing customer volume over customer quality. The corporation wagers on several lower-priced policies at higher risk rather than a smaller number of expensive premiums that offer a safer risk. The extra cash flow will thereafter be used to purchase securities with greater rates of return.
The danger is that the greater investment returns will compensate for the price difference and, most likely, pay for the claims that will inevitably arise from the increased risk.
Underwriters for the insurance firm operate in the background, while clients interact with brokers and agents. They are experts in assessing the risk of every possible policy the business may provide and, consequently, the amount of the premium. Certain hazards are actuarial, which means they are determined by demographics and statistics.
For instance, underwriters are aware that a male who is 21 years old and unmarried has a statistically higher risk of being involved in an automobile accident than a lady who is 34 years old and married. His auto insurance will be more expensive. But the older woman has a higher chance of getting pregnant, getting breast cancer, or suffering from other illnesses. Her health insurance will thus cost extra.