CIFP Knowledge series Financial Underwriting

FINANCIAL UNDERWRITING
STRUCTURE 1. Introduction 2. Financial Underwriting: Concept, Need & Issues 3. Over-Insurance 4. Rules to Determine Extent of Insurable Interest On Own Life 5. Financial Underwriting for Different types of Insurance 6. Documents/ Data for Financial Underwriting 7. Case Study On Financial Underwriting 8. Summary 9. Key-words

1. INTRODUCTION

Dont let the perfume of the premium overpower the smell of the risk. . Slogan in Underwriters Office

The underwriter is not just evaluating medical risks, but also he needs to ensure that the reason for proposing for the insurance cover, does not emanate from a perverted mind that seeks to benefit from the insurance cover, and consequently from the happening of the event insured against. Underwriting has long been established as a way of segregating abnormal risks from normal risks and applying some type of mathematical formula to assess the cost of any extra risk involved. While this is very true of medical underwriting, there is one other area where additional risk may present itself namely the economic feasibility of the insurance contract. Few underwriting issues cause as much concern, uncertainty and disagreement as financial underwriting. This unit introduces the concept of life insurance financial underwriting. It will define, in both technical and non-technical terms, what is financial underwriting. It will illustrate how financial underwriting differs from medical underwriting and other non-medical issues. It also highlights the reasons why financial underwriting is critically important to the profitability of a companys portfolio and reviews the goals and processes of financial underwriting. It will allow students to fully understand and explain the value proposition of financial underwriting and to identify and explain the importance of various types of financial underwriting documents.

2. FINANCIAL UNDERWRITING: CONCEPT, NEED & ISSUES

Concept Of Financial Underwriting The term financial underwriting does not carry too much meaning to many people. The purpose is to determine if the amount of insurance can be justified by the insurance need.

CIFP Knowledge series Financial Underwriting

During a typical underwriting training process we usually begin with the theory of mortality tables, premium rates, and the concept of homogenous groupings of insureds. Most times it is only after this, almost as an afterthought, that we look at the financial aspect. It would seem that we have put the cart before the horse. The first thing we should think about is the basic idea that, above all, an application for insurance is a contract between one or two other parties and the company, and it must make economic sense.

It is within the concerns of the underwriter to also therefore understand the apparent reasons for the clients proposal, and if he stands to benefit from the happening of the event insured, and whether the sum assured applied for is vastly in excess of the human life value of the individual. For example, if a cars market value is Rs 5 lakhs, and it is insured for 8 lakhs, there will be added incentive for the cars owner to dispose off the car and seek insurance indemnity for the amount of 8 lakhs (sum assured). That is not just unfair but also illogical. The car owner will make a fool of the insurance company, and all insurance companies shall have to shut shop, if that were to be the case. However, the car is never insured for a greater value than its present market value, and that explains the reason why the owner cannot make a profit of his cars destruction. Quite rightly, this rule also applies to life and disability risks. The proposor should be proposing for a sum assured that does not exceed the present human life value of the proposed life assured, and should not be in a position to benefit from the event happening, nor benefit the family members. Life insurance, we have already seen is an instrument to compensate for the financial loss to the dependents in the unfortunate event of the death or disability of the insured, and put the family back to the same standards of living as earlier, but not to a better one.

NEED FOR FINANCIAL UNDERWRITING The purpose of Life Insurance is to protect against economic loss resulting from the death of the insured. If the amount applied for is in excess of the amount of the potential economic loss, then poor persistency or adverse selection may occur. The role of the Underwriter is to insure that the amount applied for is justified based on the potential economic loss. This process is called Financial Underwriting. Financial underwriting is an essential part of risk analysis in personal life insurance. It helps the insurer monitor and control risks, protect the portfolio and optimise the results of the insurance activity.

The term financial underwriting prima facie; appears to convey some vast wealth assessment of highly paid executives, wealthy businessmen, lengthy balance sheets and financial statements, etc. It is true that one or many of these may come into play while determining acceptable levels of insurance. However, it should be understood that financial underwriting does not always necessarily involve huge sums of money.

We know that moral hazard refers to the intention of the proposer. If the proposal is made with an intention to seek undue advantage from the policy, then there is some moral hazard. The intention may be to get a lower premium, or make some quick money. Underwriters have

CIFP Knowledge series Financial Underwriting

to judge the existence of moral hazard through secondary factors such as lifestyles, income as compared to premium payable, reputation for integrity, present financial condition, etc. If moral hazard is suspected, the proposal is declined. One of the indicators of moral hazard is the size of the insurance proposed compared to the income. The extent of insurable interest of a person in his own life is unlimited. It is not limited to his current levels of income, since it is assumed that these levels of income can go up in the near future. Dreams may become reality at the turn of a day. A pauper may go on to win a million dollar lottery, and a struggling actor may become an overnight sensation. However, this theory or projection may not be valid while proposing for life insurance policy, because insurance premiums are to be paid out of the present income, and a persons worth is calculated by his present income; and not by what he thinks he may become a decade later. The source of income needs to be checked. If he is not paying the premium, and someone else pays on his behalf, then there could be issues of insurable interest and wager (betting). The need for insurance has to be related to current situations and not to a desirable situation of the future. If the premium paid is large compared to the income, the possibility of lapse is very high. Other possibilities include higher claims, money laundering and fraud. The underwriter has to keep an eye on these risk factors. Making a judgement on these factors is called financial underwriting. Thumb rules are just guidelines, and may not do justice in all cases.

The need for the underwriter to be aware of financial considerations starts at the lowest level, the criterion being whether the proposor can afford to pay the premiums. This can be assessed through a financial check on his income, source of income, and the total insurance sum assured already in his name. If he cannot afford the premium, which is a matter of judgement at the time of underwriting the proposal, then there will be a case of overinsurance involved and every underwriter is aware of the dangers inherent in such a situation. It is a well known fact that what is considered reasonable assessment of sum assured, premium and financial background in one case could well be a disastrous situation in another. Over the years, insurers have combined income and potential worth with insurable interest giving rise to some rule of thumb, methods for determining acceptable limits. The underwriting of financial risks is a matter of experience, and involves a greater use of common sense and the ability to reach a logical and sensible conclusion. In the final analysis, the question that insurers need to ask is: Does it make sense?

Financial Underwriting may be therefore defined as that area of underwriting which aims at ensuring that there is no question of over-insurance, or speculation or possibility of fraud arising out of pure monetary considerations. If there is evidence of over-insurance or fraud, there exists moral hazard, and there is only one decision in such cases, and that is to decline the proposal. There is no question of charging extra premiums for the risks involved in case of moral hazard, as these risks are different from the special risks that exist in medical extramortality; which can be compensated by charging extra premiums on standard rates. It is important to understand that the proposal does not come into scrutiny only when the sum assured is very large, but that it can come into scrutiny even if the proposal is for a smaller

CIFP Knowledge series Financial Underwriting

sum assured, for instance, if the annual premium is disproportionate to net annual income, or if the existing insurance cover is large enough and the proposed sum assured will make the combined or total insurance covers disproportionately larger than the acceptable value. For example, if the proposer has applied for life insurance cover of Rs 50 lakhs; and his annual income is Rs 3 lakhs, then even under the maximum insurable interest/ HLV method; he can be insured only for an maximum amount of Rs 30 lakhs (10 times annual income). If he already has an insurance cover of Rs 10 lakhs, then he will be entitled to only Rs 20 lakhs sum assured, and not the Rs 50 lakhs cover he applied for.

FINANCIAL UNDERWRITING ISSUES Like medical underwriting and underwriting special risks (residence, transport, sporting, occupational), financial underwriting forms an integral part of risk assessment in insurance. The development of money laundering and financial criminality has served to emphasize its importance. Today, it is a global market practice. In this respect, the insurer has many, vital concerns, namely:

Taking the economic environment into account (i.e. any economic and financial difficulties encountered by company directors). This type of underwriting will not be reflected in a increase price, but will result in a decision to either underwrite the business, or decline the offer or limit the sum assured. Adjusting the insurance cover to the insureds real needs. In this way, the insurer is able to provide the insured with the right advice. Assessing the risk more accurately: In order to offer appropriate insurance terms and have a clear picture of the portfolio; both the insurer and reinsurer need to know exactly what they are covering. Limiting anti-selection and thereby avoiding the influx of poor risks in the portfolio. In insurance, financial underwriting mainly applies to cases with high sums assured. In such cases from a medical point of view, applicants can usually be accepted under normal conditions, or may be slightly rated. It is then the financial aspects that will determine the decision of acceptance. Financial underwriting entails carrying out specific checks which should lead the insurer to fully comprehend the overall risk. It entails monitoring:

Insured accumulations (to prevent policyholders from taking out several policies for small amounts with several companies resulting in less screening). The overall insurance arrangement. The existence and financial health of any company or individual person (contracting party, beneficiary, insured, payer of premiums). The financial and/or economic justification for the amounts requested to cover the risk to make sure that coverage reflects the insureds real needs to avoid over-insurance. It is experience acquired from studying cases, but also access to relevant information and the means to check this information which make it possible to highlight certain suspicious risks, which should then be declined.

CIFP Knowledge series Financial Underwriting

3. OVER-INSURANCE In England, the Life Insurance Act of 1774, also referred to as the Gambling Act; introduced an important concept of life insurance; namely insurable interest. The rule was that there must be an insurable interest in the life to be insured by the person proposing the insurance. It has also been held that any person has an unlimited insurable interest in his or her own life. In case the proposor and the life assured are the same person, there is less ambiguity on the underwriting decision. However, if they are different persons, then the insurable interest is capable of being assessed on a factual basis, even though such a basis may not be the most accurate. For example, lets consider the amount of loan between debtor and creditor where the creditor has an obvious interest in the life of the debtor to the extent of the loan. Although the loan may be repayable in instalments and the actual insurable interest may be said to be a decreasing amount, the amount of the loan at the time of effecting insurance is regarded as representing the extent of insurable interest.

One of the primary considerations must be to assess the ability of the proposor to pay the premiums out of normal conditions of income and out of available income after meeting normal expenses of living. Some insurers use a rough measure of 5 times or 10 times annual income as a guide to a reasonable sum assured that can be termed as a thumb rule. However, insurers may use varied guidelines depending on the life-style of the proposor/ life assured, and other apparent risks that are uncovered during the underwriting process. The basis of maximum insurance cover may be a multiple of the annual income or the Human Life Value (HLV), whichever criteria fits the risk taking ability of the insurer. Thus, insurable interest is a matter of judgement and underwriters may use the appropriate tools depending on the underlying underwriting and risk management guidelines. A conservative insurer may have stringent underwriting norms and an aggressive insurer may have liberal underwriting norms. The quality of underwriting, both medical and financial; determine the underwriting profits of an insurer.

4. RULES TO DETERMINE EXTENT OF INSURABLE INTEREST ON OWN LIFE It is already known that the insurable interest held by a man on his own life is unlimited. Does it therefore mean that he is entitled to an unlimited amount of insurance cover, or as much as he proposes? Logic suggests that the amount of interest should be quantified. The question is How much is too much? Underwriters follow several guidelines in assessing the actual financial value of a person before arriving at a specific financial figure that is within their risk appetite. The rules/ approaches include the following:

CIFP Knowledge series Financial Underwriting

1) HUMAN LIFE VALUE (HLV) How much insurance to buy? Concept of Human Life Value: Beyond all doubt, your life is invaluable. Yet, there is a certain worth that can be attributed to the financial support you offer your parents, spouse or children. This worth is referred to as Human Life Value (HLV). In the future, if your family does not have the protective blanket of your presence, they will no longer be able to enjoy the benefits of the income you earned. Put simply, Human Life Value is the present value of your future earnings.

You should calculate your Human Life Value so you can accordingly invest in insurance plans that provide your family with adequate finances and hence security even in your absence. Your Human Life Value is determined by 3 factors: 1. Your age 2. Current and future expenses 3. Current and future income

As a thumb rule, if you are 30 years of age, you should insure yourself for an amount approximately 8 times your annual income. At 35, your investment should be close to 6 times your income. Of course, the exact amount of your investment should be determined by the number of people who depend on you, your existing investments and your life stage. For example, if you are 30 years of age and have two children and parents to provide for, the amount you invest should be reflective of your requirements.

The Human Life Value may be defined as the capitalized value of the net future earnings of an individual after deducting appropriate costs for self maintenance. From the point of view of dependents, an individuals Human life value represents the measure of the value of benefits they can rightfully expect to get from their bread-winner. Likewise, form the standpoint of an organisation, the human life value on one of its key employees is a measure of the value of his or her services to the organisation.

In 1924, S.S Huebner of Wharton School of Finance and Commerce, University of Pennsylvania, U.S.A; suggested that the human life value concept is not just a statement that a human life has an economic value but implies that the five aspects as follows:

1. Appraisal and capitalization of human life value 2. Recognition of family as an economic unit organized around human life values 3. Human life value and its protection as the main link between present generation and the succeeding generation 4. Recognition of human life value as creator of property values 5. Application of scientific principles of business management to life values

CIFP Knowledge series Financial Underwriting

Capitalization of economic value of a human life is possible through life and health insurance. By guaranteeing this capitalized value in the event of death, life insurance tries to perpetuate the earning capacity of an individual life for the benefit of its dependents. With the bread winners death, the whole value will be swept away. Life insurance acts as a hedge against such a loss. It is the only scientific method of capitalizing the economic value of a human life and indemnifying for its loss in case of premature death.

There is a tendency these days to regard maximum insurable interest or HLV, on a persons own life to be represented by the value of future earnings. The younger a person is, the greater will be the amount of anticipated earnings, if one assumes increasing earnings over the years, and the rate of inflation. Thus, it may produce maximum insurable interest also referred to as HLV, of say, 5 to 20 times (depending on age) of present annual earnings and with the low premium rate presented by term insurance, the resultant premium may be very low and hence affordable and in line with the earnings of the proposor. In such cases, it is not the premium affordability that needs to be checked, but whether the person deserves the high sum assured proposed, and if granting the high insurance cover may pose moral hazard risks. The idea is to compensate the dependents of the life assured for the financial loss suffered, and not make them profit from the insureds death. The question that has to be asked is Does it make sense?

For example, if the proposer applies for a Rs. 50 lakhs life insurance cover, and according to his income, he can be entitled to only Rs 30 lakhs maximum sum assured; then it will not matter if he can afford to pay the premiums or not. The premium for a pure term insurance policy for a person aged 30 years, and for a sum assured of Rs 30 lakhs is approximately Rs 10,000 per annum; which can be easily afforded by the proposer. However, what is to be seen is whether he deserves that high cover. The common sense approach is to ask the question Will the person be more useful after death than while he is living? If the answer is yes, the proposal is inherently risky, and should be declined on grounds of moral hazard. The whole concept of life insurance is to bring the dependents to the same standard of living as before the death of the insured, but not greater. That is, insurance is not meant to be taken as a financial instrument to profit from ones death. The word afford is to be distinguished from pay. The proposor may be in a position to pay the premiums but does he afford it? Even if he can afford to pay, does he deserve the risk cover? These are primary points of consideration that every underwriter needs to ask as a part of the process of underwriting. If there is evidence of over-insurance, then there is a moral risk which cannot be assessed accurately. Reducing the sum assured applied for, does not remove the moral risk, as the proposor may seek additional coverage from another insurer. Thus, emphasis must be laid on two factors, namely: the need for the amount applied for, and the ability to afford the premiums.

CIFP Knowledge series Financial Underwriting

Thumb rule: Without going into the mathematical aspects, if a person aged 40, earning Rs 20,000 per month, i.e; Rs 2,40,000 per annum, dies leaving behind dependents in the form of his wife and children; the annual economic loss to the dependents is the loss of his income i.e Rs 2,40,000. However, that will take care of the needs of the family for a couple of years only. What about the rest? Hence, thumb rule of maximum 10 times the annual income to maintain the existing standard of living of dependents, or say a minimum of 5 times the annual income to meet expenses; is used. E.g; if the deceased had a life insurance cover 10 times his income, the sum assured payable to the nominee would have been 24 lakhs. The logic is that, this 24 lakhs if deposited in a bank, would generate assumed interest @10% i.e Rs 2.4 lakhs, exactly the sum the deceased earned before death. That is why life insurance is used to maintain the same standard of living of dependents in case of unfortunate death of the life assured.

2) The 20% Rule This rule states that the total annual premiums should not exceed 20% of the after-tax income. Even though may people may not afford premiums as high as 20% of the after-tax income, and some may prefer higher premium payouts in excess of the said figure, there cannot be a fixed value assigned to all. However, this rule is a thumb rule to ascertain the affordability and intention of the proposer, and any premium in excess of this figure may lead to over-insurance. This rule fails in the case of term insurance affordability, where a person earning Rs 10 lakh per annum, could afford (at 25% of after-tax income) an annual premium of say 1.5 lakhs (at Rs 5 per thousand sum assured), which would purchase a sum assured of INR 250 lakhs (too high cover). The 20% rule did not envisage this scenario.

3) The Needs Approach The assumption in the Human Life Value or maximum insurable interest approach is that people (especially young people) are going to earn the same income (or greater income) throughout their working lives, which is not necessarily true. Thus any calculations based on continuous earnings at the current level would possibly be exaggerating the situation. In later years, say after 40 age, financially the family gets into a more settled zone, and the needs approach can be regarded as a reasonably accurate method of assessing loss of future earnings as a result of death. The needs approach takes into consideration different life stages, and the various financial needs that arise at these stages. For example, while doing a need based analysis of the prospective client, we collect data relating to his personal and official life, and recommend insurance and investment solutions depending on his present status, his future needs, and the gap that exists in the investment to meet those needs. We take into consideration the need to invest for childrens education based on the age of the children, the rate of inflation, the target education envisaged, and the funds that would be required at that stage to fully finance the education. Similar strategy can be used to prepare for retirement needs for self and spouse. This approach is based on analyzing the various financial needs of the proposer and his family members and is thus referred to as Needs

CIFP Knowledge series Financial Underwriting

Approach. The Needs approach is the most popular tool used by insurance agents and distributors worldwide, and makes sense from a financial planning perspective too.

ACTIVITY A

1. You are the underwriter of Insurance Company X. You receive a proposal from a husband (earning member/ payor of premium) for an insurance cover on the wifes life. The husband is not insured. The proposal on the wifes life is for a sum assured of Rs 30 lakhs. The husbands monthly income is Rs 50,000. What will your decision be, in terms of acceptance/ rejection/ or modification of policy terms. Justify your answer. 2. You are the underwriter of Insurance Company Y. You receive a proposal on the life of a person who is a director of a company, and draws annual income of Rs 25 lakhs. The company has proposed the policy and will be the premium payor. The death benefit will go to the company. The sum assured proposed is Rs 1 Crore. What type of policy is this? What financial considerations will you make before deciding on the acceptance of the proposal?

5. FINANCIAL UNDERWRITING FOR DIFFERENT TYPES OF INSURANCE

1) PERSONAL INSURANCE Personal Insurance replaces lost earnings caused by premature death. This includes special needs such as mortgage life insurance and college funds. Multiples of income are usually used to justify personal insurance amounts; most individuals do not have as much insurance as they could qualify for, so amounts in excess of the tables should be analyzed carefully to be sure they are justified. Inspection reports, copies of tax returns, income statements by CAs, copies of employment contracts etc can be used to verify earnings if the amount applied for appears unusually large. Table 1 Table illustrates maximum insurance cover for different age slabs as guidelines for Underwriters of Company A

Typical Personal Income Tables Age 18-40 Age 41-50 Age 51-69 Over 69

Maximum Insurance Cover 15 * Annual Income 10 * Annual Income 5 * Annual Income 3 * Annual Income

But what if the amount applied for exceeds these multiples?

CIFP Knowledge series Financial Underwriting

Guidelines are intended to guide our decisions but are not the same as rules which must be obeyed. Underwriting Judgment is needed to make reasonable exceptions to the guidelines when it is appropriate to do so.

Questions to ask (for underwriter): 1. Does it make sense? 2. How good are the sources of information? 3. Will the person be worth more dead than alive to family or business?

Some insurers are conservative and others are aggressive, as far as underwriting standards are concerned. For example, a particular insurer may view a diabetic proposer as risky business, while another may accept the proposal with extra premium. Indian Insurers have different slabs for introducing financial underwriting. For example, some insurers ask for financial documents like income statements, employment proof, etc; for all proposals exceeding Rs 10 lakhs sum assured. For higher sum assured proposals, more documents such as tax returns filed, bank account statements, etc may be called for.

2) ESTATE CONSERVATION (POLICIES) Life Insurance can be used to prevent forced sale of Estate assets for estate taxes. Life Insurance can also serve to conserve the estate for heirs. Creation of an estate, however, by insurance in excess of estate conservation needs is speculative and uninsurable. Proposals for life cover on this basis are invariably not supported by good documentation, and even if they are, the documentation may be of a temporary nature changing as time goes on by the desire on the part of the proposer to reduce his tax liability as mush as possible. Thus, even though it may seem logical to permit life insurance to cover the total liability for estate taxes, in practice some type of lower limit must be applied. This lower limit should take into consideration the amount of personal insurance already held by the proposer, otherwise it may be a case of over-insurance. Estate settlement recognizes the fact that there being an estate, there is income too. In determining the level of premiums which can be afforded, total income should be taken into consideration.

3) OLD AGE POLICIES (MATURE MARKETS) Longer life expectancies and wealthier senior citizens have created a significant market for Life Insurance in the Mature Market. Mortality is volatile as older individuals are more vulnerable to impairments than younger individuals. Adverse selection is potentially greater as children who are aware of problems seek insurance for their parents

4) JUVENILE (CHILDRENS) POLICIES Juvenile policies are often purchased for savings, as gifts and to guarantee future insurability. Parents should be the proposer and payor, child should be the beneficiary of the regular payouts; In case of payors death; Waiver of premium benefit should be activated, and all benefits inherent in the policy should be paid as and when they mature, to the child.

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CIFP Knowledge series Financial Underwriting

Grandparents may be owner and/or premium payor. It is advisable to have all siblings similarly insured. Parents should have a significant amount of coverage as well; usually twice the insurance on the juvenile. Parent or guardian must sign proposal to show agreement for the insurance and to attest to correctness of application questions. Payors financial affordability should be positive as far as the premium payable is concerned. All matters relating to physical, occupational and moral hazards should be stated in true and correct manner, and the fundamental rules of utmost good faith, and insurable interest should be satisfied.

5) BUSINESS INSURANCE Businesses are generally classified as small, medium or large, depending on their turnover, the number of employees and the spread of their business activities. In case of a small business, usually it is a one-man-operation, and in case of raising capital from banks, there is a need for life insurance in the name of the person to whom the loan is being advanced. The lender needs to be assured that the borrower is capable of repaying the loan and secondly, that in the event of the unfortunate death of the borrower, life insurance will cover the situation i.e the lender will be compensated for the amount of the unpaid loan through the insurance claim. The lender actually underwrites the ability of the borrower to repay, with life insurance taking care of loss caused due to death. Thus life insurance policy acts as an additional guarantee for advancing the loan (collateral security).

The underwriter needs to have special skills in appraising the amount of the loan agreed upon between the borrower and the lender and being able to reconcile the amount of insurance applied for as not representing over-insurance. The primary consideration must be the business acumen of the borrower, which can be deduced from the past history of the company, or through the financial statements including tax returns relating to the past few years of operation. The future cash flow can be projected through these statements. In other words, the underwriter needs to satisfy himself that there is no speculation either on the part of the proposer or on the part of the lender. The total amount of the loan must be realistic in terms of the business operation and in terms of the ability to repay and the insurance coverage must also be appropriate to the anticipated repayment. Any amount that exceeds such genuine requirements indicates over-insurance and can create a high risk situation for the insurance company in terms of the possible failure of the business operation. As with personal insurance there must be a greater value from the continued life of the insured than that provided by the death benefit resulting from the premature death of the insured. Overinsurance is speculation and can lead to suicide or homicide if the policy on the insured has greater value than the economic advantage provided by the continued life of the insured. The business must be in good financial health in order to justify any type of business insurance.

6) KEY MAN INSURANCE An employee is called a key employee if he is very important to the successful operation of the firm. An employer has insurable interest in the life of a key employee. Such insurable interest

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is limited to the loss which the employer would sustain in the event of the death of the employee. The value of a key person to a business must be demonstrated based on skills, contacts or knowledge. It is usually evaluated based on multiples of compensation for the number of years needed to replace the person and recover the losses (5-10x). Compensation includes gross salary, regular bonuses, benefits, significant perks, stock option values and profit-sharing arrangements

A valid insurable interest requires an assessable loss sustained by the employer and the extent of the insurable interest should not go beyond the extent of a reasonable assessment of that loss. The major loss sustained by an employer must relate to the transition period where loss of business and consequential profits may be sustained and to the cost of seeking and possibly training a replacement. The salary paid to a key employee is a reasonable measure of his worth to the company, and therefore an appropriate multiple of annual salary is used as the base for determining the extent of insurable interest. In general terms, this multiple is usually taken as 10 times the annual salary as representing the human life value of the key person. This maximum would apply to a key man situation where the company could be reasonably assured of at least 10 years future service. It is prudent to be cautious in case of proposals for more than five times annual salary.

Some underwriting rules that should be borne in mind while effecting a key man insurance policy are as under: Look for other key persons in the firm to be similarly insured Avoid accepting risks where key person is significantly impaired as this usually represents adverse selection Key Person insurance on individuals nearing retirement is not acceptable except for minimal amounts unless satisfactory justification is provided.

7) ADDITIONAL ACCIDENTAL DEATH BENEFITS & OTHER RIDERS A rider is a clause or condition that is added on to a basic policy providing an additional benefit, at the choice of the proposer. Riders can be added to any basic life insurance policy. They enhance the insurance cover by the value of the sum assured (S.A) added as rider. For example, if the basic sum assured for an endowment policy is Rs 5 lakhs, and an additional term rider is attached to the policy for the same amount, then the total sum assured payable on death of the insured becomes Rs 10 lakhs. In case of Accidental Death Benefit (ADB) rider, the claim payout is double the Sum Assured, in case of death due to accident. Permanent disability benefits include an additional sum assured for covering loss of limbs, eyesight, hearing, speech, etc. A specified percentage of the basic sum assured is paid in case of partial disabilities mentioned in the schedule. Riders include additional payments on sickness, critical illness, waiver of premiums, partly or fully, under certain conditions. Riders add variety and flexibility to the nature of the policy. Riders can be added or removed at the will of the policyholder at policy anniversaries.

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According to the IRDA Regulations in April 2002, and amended in October 2002, the premiums on all riders relating to health or critical illnesses, in the case of term or group products shall not exceed 100% of the premium of the main policy. The premium on all the other riders put together shall not exceed 30% of the premium on the main policy, and the benefits arising under each of the riders shall not exceed the S.A under the basic product. This restriction

puts a limit to the number of riders that can be offered with any policy. These limits may be amended from time to time. The premium for accident benefit rider does not depend on the age of the proposer or life to be insured. For being eligible to get the accidental death benefits, there are certain conditions to be satisfied, and these conditions are specified as part of the terms and conditions in the prospectus or product brochure.

The problem facing the life underwriter is one of amount of insurance. Since there are double or triple accidental benefits that go with the basic policy, these high levels of insurance covers may increase the risk substantially for the insurer, and hence certain restrictions are put through the terms of the policy, or through an overall cap on the total accidental covers granted to a life assured. Any amount in excess of that, irrespective of the size of the basic life insurance contract, should be regarded as speculative and requiring closest underwriting scrutiny.

6. DOCUMENTS/ DATA FOR FINANCIAL UNDERWRITING In case of large sums assured, the underwriter may ask for additional medical reports, or consult senior officials if moral hazard is suspected. The officials are expected to make enquiries about the life to be insured and their family, their occupations or businesses, their income levels and life styles, their source of income, etc. Proof may also be sought by these officials to substantiate the reports. The agent, also known as the primary underwriter has to give his report in all cases. This report is referred to as Agents confidentiality report (ACR). Some documents and related guidelines are explained as under:

A. PROPOSAL FORM: The application form technically referred to as Proposal Form, is the primary source of obtaining data for financial underwriting. The proposal form contains material information to be filled in by the proposer, namely; facts relating to the annual income, occupation, source of income, previously held basic insurance covers along with riders and a declaration at the end, to the effect that all stated facts are true and correct. Thus basic financial information is collected through the proposal form itself, which is considered as the basis of the life insurance contract. Other documents that act as secondary information providers include the ACR, income statements, tax returns, Financial statements, bank account statements, Anti-Money Laundering (AML) documents and Know Your Customer (KYC) documents.

B. INCOME STATEMENTS For a person, earning income under any of the heads of Income Tax, the word income means income earned in a financial period, through one or many sources, and aggregated

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for the purpose of computing income tax. Thus income statements for an employee refers to the salary statement from employer, bank account statements, income statements from other heads such as business, profession, property, and other sources such as dividends, capital gains, interest earned on investments, etc. For high sum assured proposals, the underwriting guidelines usually are more specific, and underwriters may ask for one or many of these documents for risk appraisal. Issues relating to insurable interest and overinsurance have to be dealt simultaneously. Prudent underwriting guidelines must be followed, however, in some cases; judgement based on experience may be a better idea. In case of business income; income statements summarize the results for a specific period of time; also called profit and loss statements. Insurance granted should be a rational multiple of the income earned by the businessman, and should not be grossly exaggerated, so as to enhance the risk of the insurer.

C. BALANCE SHEET It refers to a snapshot of the companys financial position at a single point in time (such as close of business at the end of the year). Assets are listed on the left; liabilities and capital on the right; both sides should be equal or in balance. If current assets are less than current liabilities it may indicate a business that is in trouble as other assets may be difficult to liquidate quickly enough to satisfy the demand to pay current liabilities.

D. RATIO ANALYSIS Certain ratios give a quick picture of the viability of the business. Current Ratio is Total Current Assets divided by Total Current Liabilities; should be at least 2:1. Debt/Worth Ration is Total Liabilities divided by the Tangible Net Worth; usually less than 1.0if debt load too is great, the company may have trouble acquiring additional funds if needed.

E. KYC (KNOW YOUR CUSTOMER) INFORMATION Clause 3.1.1 of the AML (Anti-Money Laundering Bill/ Master circular dated November 2008) guidelines makes the Know Your Customer (KYC) for Life insurers mandatory. Accordingly, Life insurance companies are required to carry out KYC norms which include determination and documentation of the true identity of all customers requesting for its services. The objective of KYC guidelines (is to prevent banks (and insurers) from being used, intentionally or unintentionally, by criminal elements for money laundering activities. KYC procedures also enable banks (and insurers) to know/understand their customers and their financial dealings better which in turn help them manage their risks prudently.

Banks & Insurers should frame their KYC policies incorporating the following four key elements: 1. Customer Acceptance Policy; 2. Customer Identification Procedures; 3. Monitoring of Transactions; and

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4. Risk management.

Banks & insurers need to obtain sufficient information necessary to establish, to their satisfaction, the identity of each new customer, whether regular or occasional, and the purpose of the intended nature of banking and insurance relationship. Being satisfied means that the bank must be able to satisfy the competent authorities that due diligence was observed based on the risk profile of the customer in compliance with the extant guidelines in place. Such risk based approach is considered necessary to avoid disproportionate cost to banks and a burdensome regime for the customers. The KYC guidelines of RBI mandate banks and insurers to collect three proofs from their customers. They are: 1. Photograph 2. Proof of identity 3. Proof of address F. PAN (PERMANENT ACCOUNT NUMBER) From 01.08.2009, IRDA decided to mandate the requirement of PAN on all high value insurance products. All Insurers are therefore required to collect PAN from all persons purchasing insurance products where the contracted annual premium payable on the insurance policies, per policy basis, exceeds Rs. 1.00 lakh.

With all the guidelines, Financial Underwriting can be summarized by just these few words applied to the case at hand: Does It Make Sense? (Charles A. Wills 1973 text)

7. CASE STUDY ON FINANCIAL UNDERWRITING Facts: 49-Year-Old Female Manager and Company Director Term insurance Term: 20 years Sum insured: INR 1 crore Additional benefits: Critical Illness (CI): INR 50 lakhs ADisB (Accident Disability Benefit) Rider: INR 50 lakhs Waiver of Premium (WOP) Proposal year: 2009

Solution With regard to the medical assessment, we assume that all the documents required for the requested sum insured were available. From a medical underwriting perspective, the available information indicates that the risk can still be accepted on normal terms. Since the sum insured is very high in this case, the focus is on financial risk assessment. To determine whether the requested sum insured is appropriate in relation to the applicants annual income, we have the financial questionnaire, from which we can extract certain information.

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The requested sum insured is INR 1 crore. The insurance needs were not defined entirely clearly, as both key-person insurance and loan security were specified in the Financial Questionnaire (FQ). From the other information provided in the FQ, the sum insured may initially be divided as follows:

1. Key person: INR 40,00,000 2. Loan security: INR 60,00,000

Regarding 1: Key person insurance In assessing key-person risks, it is important to know or to clarify the following information: What precisely are the prospective insureds capabilities, knowledge and qualifications? We know only that she works as a manager and director. Is the sum insured appropriately proportionate to the prospective insureds income? From the general financial data provided in the application, we know that in 1999, the prospective insureds monthly income amounted to INR 1,00,000. The maximum sum insured for a key-person policy should be between five and ten times the applicants gross annual income. Does the company have sufficient funds to pay the premium? Is its business stable enough? The company was founded only 2 1/2 years ago. We have the figures for its gross and net profits in the years 2006 and 2007), but have not yet received any information on the year 2008.

Regarding 2: With regard to the portion of the sum insured that is obviously intended to provide security for a loan, the documents provide the following information:

The amount of the loan is INR 60,00,000. The term of the loan is 15 years, while the term requested for the policy is 20 years.

Summary of facts and recommendations This example involves a high sum insured. For a key-person cover, the sum insured of INR 40,00,000 is justifiable. According to the information provided in the questionnaire, the key person owns 80% of the company and participates to that extent in the companys profit, as well. Given the size of the requested sum insured, it is necessary to obtain information on the prospective insureds income from some independent source. As a rule, unconfirmed information from an applicant regarding his/her financial background is insufficient since it is often based on subjective estimates that have been rounded upward. The application states that the policyholder will be the company, which will also pay the premium. To determine whether sufficient funds are available to pay the premium, it would be helpful to obtain at

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least the balance sheets for the last two years (2007 & 2008). 20 years is too long a term for a key-person policy. We recommend a term of at most five years. This makes sense because the cover should be checked after five years to determine the following: Is the insured still a key person? Has the companys profit or the income of the key person changed and consequently made it necessary to recalculate the sum insured? With regard to securing the loan, the loan commitment or contract must be submitted to allow the statements made in the FQ to be verified. The sums requested for the additional benefit riders are also very high. With extremely few exceptions, it is very difficult to justify such high sums insured, which is why it makes sense to set and abide by absolute limits. Large sums for accidental disability benefits, in particular, often represent a high subjective risk.

Our recommendation for the AdisB rider would be a maximum of INR 20,00,000.

In the case we are now considering, the company would obviously like to protect itself against the eventuality that the key person could be lost due to critical illness (CI). The basic purpose of CI cover is to cover costs arising as a consequence of a CI (for example, for treatments, illness-related modifications to the home, etc.). That is why, with regard to this cover as well, it is advisable to set absolute limits on the sum insured that are in keeping with the presumable actual costs. We therefore recommend limiting the CI cover to a maximum of INR 10 lakhs. The approach taken in this case of requesting a limit of indemnity equivalent to the replacement costs should be seen very critically because, even in the event of a critical illness, the key person would not necessarily cease to be available to the company from one day to the next and in many cases could even continue to perform his/her tasks more or less unhindered.

The question to be asked is: Is the sum insured appropriately proportionate to the prospective insureds income?

In order to arrive at a final decision, therefore, it will be necessary to obtain the following documents: 1. Proofs of the key persons income from an independent party 2. Information on the companys financial standing, i.e. the balance sheets for the last two years 3. A copy of the loan contract

To the extent that these unresolved points can be clarified without any reservations, our conclusive recommendation is to split the cover applied for into the following: Key-person cover with the above-suggested modifications regarding the sum insured and term; Loan security with a sum insured and term corresponding to the loan contract (i.e Rs 60,00,000 sum assured & 15 year term).

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ACTIVITY B

1. CASE STUDY Facts: 50 age; Male/ Mr. Mahesh; Director of Company, turnover INR 500 crores. Term insurance Term: 20 years Sum insured: INR 5 crore Additional benefits: ADisB (Accident Disability Benefit) Rider: INR 2 crores Waiver of Premium (WOP) benefit applied for. Proposal year: 2009 Retirement age: 60 Home loan cover: Rs 1 crore (Value of home loan) His health is perfectly standard, and he has no major ailments. He owns 5% of the company shares, and draws an annual income of Rs. 50 lakhs. You are required to offer recommendations for underwriting the risk. Justify your recommendations with appropriate reasons.

2. Visit 5 life insurance company branch offices, and collect data relating to the financial underwriting norms and the various documents and questionnaires forming part of the financial underwriting process.

8. SUMMARY The role of the Underwriter is to insure that the amount applied for is justified based on the potential economic loss. This process is called Financial Underwriting. Financial underwriting is an essential part of risk analysis in personal life insurance. Financial underwriting does not always necessarily involve huge sums of money. If the proposal is made with an intention to seek undue advantage from the policy, then there is some moral hazard. One of the indicators of moral hazard is the size of the insurance proposed compared to the income. Financial Underwriting may be defined as that area of underwriting which aims at ensuring that there is no question of over-insurance, or speculation or possibility of fraud arising out of pure monetary considerations. If there is evidence of over-insurance or fraud, there exists moral hazard, and there is only one decision in such cases, and that is to decline the proposal. One of the primary considerations must be to assess the ability of the proposor to pay the premiums out of normal conditions of income and out of available income after meeting normal expenses of living. Some insurers use a rough measure of 5 times or 10 times

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annual income as a guide to a reasonable sum assured that can be termed as a thumb rule. Underwriters follow several guidelines in assessing the actual financial value of a person before arriving at a specific financial figure that is within their risk appetite. The rules/ approaches include the following: Human Life Value/ HLV; The 20% rule, and the Needs Approach. The basic financial information is collected through the proposal form itself, which is considered as the basis of the life insurance contract. Other documents that act as secondary information providers include the ACR, income statements, tax returns, Financial statements, bank account statements, Anti-Money Laundering (AML) documents and Know Your Customer (KYC) documents.

9. KEYWORDS Financial Underwriting: The process of ensuring that the amount applied for is justified based on the potential economic loss. Moral hazard: refers to the intention of the proposer Over-insurance: refers to obtaining insurance cover in excess of certain standard guidelines set by insurers. It benefits the life insured, and increases the risk for the insurer. Human Life Value: defined as the capitalized value of the net future earnings of an individual after deducting appropriate costs for self maintenance; also referred to as maximum insurable interest. Key-man Insurance: Policy taken on the life of a key employee, and premiums paid by the company. An employer has insurable interest in the life of a key employee to the extent of the loss which the employer would sustain in the event of the death of the employee.

Knowledge Series FINANCIAL UNDERWRITING CIFP

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