Insurance-UnderwritingMedium

3 min read · 532 words

What the seat actually does

An underwriter agrees to pay if something happens, in exchange for a premium now. The whole of the job is deciding what that promise is worth before anybody knows whether it will be called.

The cost of the product is unknown when it is sold. No other business in finance has that shape: a bank knows what a loan cost it, a desk knows what a hedge cost, and an insurer finds out over the following decade. Everything else here — reserving, reinsurance, the cycle — follows from that one fact.

• Pricing — expected claims, the cost of the capital held against them, and the expenses of writing the policy.
• Selection — deciding what to write and what to decline, which matters more than the rate on what is written.
• Reserving — setting aside what has been incurred but not yet reported, which is an estimate about an estimate.
• Reinsurance — buying cover for the tail, including instruments like a catastrophe bond.

A day, and where it goes

• Submissions — risks offered, and the ones worth quoting at all.
• Terms, which is where the real pricing sits: exclusions, deductibles and limits move the expected loss more than the rate does.
• Accumulation. How much of the book is exposed to one event, which is the question a single storm asks.
• Claims development — what last year's book is turning out to have cost.

What it is measured on

• The combined ratio — claims and expenses against premium. Under a hundred means the underwriting itself made money before any investment return.
• Reserve development. Whether last year's estimate is proving too high or too low, which is the honest scorecard.
• Accumulation against limit for a single event.
• Retention, since renewing a known book is worth more than writing an unknown one.

What it touches on this site

• The instruments — cat bonds, life settlements and annuities.
• The other half of the firm — insurance investment, which invests what this seat collects.
• The nearest thing in markets — credit default swaps, which are the same shape with a different name. See credit derivatives.
• What a claim is worth — risk measures, for the tail this seat is actually selling.

How it goes wrong

• The cycle. Capital arrives after a quiet year, rates fall, everybody writes more, and the loss is discovered in the year it stops being quiet.
• Accumulation nobody added up. A thousand small policies in one flood plain is one policy.
• Reserves released too early, which turns an estimate into reported profit and is very hard to take back.
• Correlation across a book assumed away, in exactly the events where it does not hold.

Concepts to master

• The premium is the expected loss plus the cost of the capital held to be able to pay it — the second half is what makes it a business rather than a bet.
• Adverse selection. Whoever most wants the cover knows something about the risk.
• Tail risk is the product, not a footnote to it — see risk measures.
• Diversification works until the event is common — see diversification.