In four words, insurance underwriters price risk. Whether it’s a Ford KA or the Candy brothers’ property portfolio, an underwriter will decide how much they should charge their client to insure them against a certain situation arising.
Whether its travel insurance, home insurance or insurance for your business everyone has to buy insurance at some stage and for an underwriter it’s the same concept for most products – you guarantee payment if a situation you cover occurs in return for a set amount of money, i.e you bear their risk in return for premium. So if one of your clients breaks his leg, you will pay for their operation and rehabilitation, or if your client crashes his car, you will repair it.
Let’s upscale and look at the more exciting stuff. Imagine one of your clients ran the company that owned and managed Lake Tahoe dam and reservoir, if it wasn’t owned by the US government, and you were an underwriter specialising in hydro-electricity projects.
You sell them $100 million of cover in the event an earthquake damages the dam and causes consequential damage to the surrounding area and you charge them 5% or $5 million for the cover. As the underwriter, you would have had to underwrite this risk and calculate the price.
Before you decide to accept the risk, the broker presents you with all the information you need to make an informed decision: its location, size, build materials, proximity to populated areas, amount of homes it supplies water to, claims experience etc. You would assess the dam’s build type, quality of construction and age, then calculate how much it would cost to repair if damaged. You would also have to consider how much collateral damage it would cause if the dam burst and how much it would cost to rebuild and clear up the damage.
Using all of this information, you come up with an average claims cost for the year. You then need to calculate the probability of this event occurring. Using proprietary or third party models you would analyse the San Andreas Fault’s historic earthquakes and magnitudes whilst using synthetic data to model potential earthquakes.
With this information, you would come up with a probability of certain events occurring – minimal damage through to total destruction – and the cost of these events. From this you can create an average cost of claims for the year – call it $3 million.
That means that for every $5 million you collect in premium, you expect $3 million to be spent on claims.
As an underwriter, you also need to consider your expenses – the broker’s commission, your wages, the rent, etc, and add this to the price of the claims. You would also factor into this the cost of capital and your profit, which in total makes $2 million. Therefore you need to charge a price of $5 million to cover all your costs.
Being a specialist hydro-electric project underwriter, various brokers come to him with similar risks, and he builds up a portfolio of dams and other hydro-electric projects that are situated across the world. Throughout the year, he builds a book of varying sized risks spread through the world. He does this in order to manage his risk and collect enough premium to ensure he has the financial strength to pay out if one of the dams he insures collapses. In the event that he doesn’t have that financial capacity, he would have to go to another insurer and share the risk with them, for a proportion of the premium.
They have to do all of this, and still make time to form and maintain relationships with their brokers, go out to lunch and plan what Olympics events they are going to take their brokers to. Boom!
If you think you’d make a good underwriter, read: Broker vs Underwriter for a better understanding of what it takes.