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Underwriting risk is the potential for economic loss that an insurance company might experience if it agrees to provide coverage to an individual or organization. It also can refer to a specific set of named perils or to broader, blanket coverage. An insurance company measures the probability of an insurance payout through the process of determining underwriting risk.
One way that an organization might seek to manage its risk of economic loss is to share the risk with an insurance company. In exchange for insurance premiums, the insurance company assumes the risk of economic loss. In order to determine how much of a premium should be charged to the organization, the insurance company conducts underwriting. Insurance underwriting is the process by which an insurance company determines the likelihood and severity of a potential loss — the underwriting risk.
The underwriting risk is determined by exposure to certain perils and hazards. An underwriting peril is something that directly causes an economic loss. A hazard is a situation that exists that makes a loss from a peril more likely. For example, if an organization seeks to insure a building it owns from damage, potential perils might include fire, wind and flood. Hazards would include whether flammable material is stored in the building, whether the building is located in an area at high risk for wind or flood damage or if it is poorly constructed.
When the insurance company looks at underwriting risk, it would examine such factors as the age of the building and its electrical wiring, the materials from which it is constructed, its proximity to a fire hydrant and fire station and whether the building meets certain standards for fire or wind resistance. When those factors are measured, the company can then formulate a cost that it would need to collect from the organization in order to be willing to accept the underwriting risk. This cost is called the insurance premium. The underwriting risk is the total amount that the insurance company is liable for in case of a loss. If the organization does suffer an insured loss and the insurance company is liable to indemnify the organization, the reimbursement is called the insurance payout.
An insurance company determines its underwriting risk not only on a case-by-case basis but also by examining a pool of risks. When risks are pooled together, it becomes more likely that only a small amount of underwriting risks will result in losses to the insurance company. If the insurance company does an effective job of underwriting, it will collect more in insurance premiums than it will pay out in claims.