Underwriters Compete on Moral Judgment

(note: this is essay 1 of 4 on the social science of insurance)

A great underwriter possesses many skills: communication skills, analytical skills, administrative skills, sales skills, leadership skills. However, the skill that most differentiates great underwriters from the rest is moral judgment. 

Moral codes are our internal rules for how we will conduct ourselves, in good and difficult times. They outlaw certain behaviors and act as a way to credibly signal to others that we can be trusted. Virtue is a value-laden term, it’s an evaluation of one’s moral code against a benchmark of some kind. The virtue that matters for insurance is composed of both the quality of a buyer’s intentions in entering into an insurance contract and also the buyer’s wisdom and experience. It is necessary that the buyer is honest and forthright but it is also necessary that they will not change their character later once they learn some new facts about the world.

The kind of virtue underwriters are evaluating is very specific. There are many forms of virtue and not all relate to the qualities necessary to be a virtuous insurance customer. For example it is virtuous to be a supportive parent, give to charity and be faithful to your spouse. None of these directly matter for insurance. The form of virtue underwriters assess concerns your conduct in dealing with distant financial institutions and whether you will treat them well in the future. This is not a kind of virtue that has existed for all of human history nor one that exists everywhere in the world today. In some ways it’s a very peculiar thing to have a moral code that constrains our actions in dealing with corporations. And we don’t all have it to the same degree. 

This is distinct from the work of risk assessment. Risk assessment as insurers undertake it is to assign a risk to its most appropriate segment. Classifying and aggregating risks to determine their costs is an important function of insurance companies but it is not underwriting.

The underwriting of a person or business starts with an assessment of the quality of someone’s intentions, which in a sense is a forecast of that person’s future actions. The most broad and general guide for those actions is morality. 

Testing morality works to weed out two different kinds of failures of insureds. First is a group that intends to do something bad1 but is trying to conceal it. As an agent, I once sold a hospital indemnity2 policy to a woman that knew she had cancer and would be going to the hospital in a few days. She somehow got through underwriting (possibly by lying) and filed a claim almost immediately after her policy was issued. I also once saw a trucking customer file a total loss ($1m) at 12:01am on the very day their insurance policy came into force. What did they do wrong? I never found out, but it was very suspicious!

The second is a group that might not intend bad actions now but is especially vulnerable to bad behavior in the future. As a reinsurance broker I had an insurer client that was entering a new line of business. The management team scored high on the integrity scale, they were good people. But when the reinsurance actuaries came into their office for an audit of the pricing model it was clear this group had no idea what they were doing and were systematically mispricing risks in a myriad of ways. They simply were ignorant of how to do their jobs. This is a failure of knowledge and wisdom, not of intentions.  

In our daily lives we make judgments of virtue all the time in selecting friends and colleagues and partners of various kinds. In normal life these judgments are heavily influenced by our existing relationships. Moral judgment is a social act. We would have a difficult time accepting or perhaps even understanding the moral evaluations of someone from a very foreign social context or culture. Since our existing relationships share this context they help our evaluation of the virtuous character of another person and offer advice.

Since the evaluation of virtue is so very important, this skill has been the subject of intense competition throughout the history of insurance. And insurers have discovered how to identify and train a talent in certain people so that they don’t need a whole village to pass effective moral judgments: these are the great underwriters. 

In normal life moral judgment is a maximizing exercise. Inasmuch as we make explicit decisions about virtue we approve of those who have a lot of it. Over time we probably select lower levels of virtue in our compatriots through implicit processes hidden to our conscious minds, but we are very unlikely to admit that. Moral judgments by great underwriters are all explicit and must contend with the fact that an insurer can make money by selling to people in a whole range of levels of virtue. 

Virtue vs Profit

You’ll notice that the slope of the line drops off quickly as virtue declines. The least virtuous are nearly certain to be unprofitable.

But how virtuous do you want your customers to be? Well, to anyone who has taken an economics class, you know where to draw the line.

Easy in theory

But what does this mean operationally? Answering this requires knowledge of both an individual’s virtue and the virtue dynamics of the marketplace. Here’s a question: how virtuous are the customers available to you today through your distribution channels? 

Low virtue customers are much easier to acquire than high virtue customers. Partly this is driven by their unprofitability being uncovered by carriers through non-virtuous behavior (and so they get non-renewed from the portfolio). These buyers also work hard at deceiving insurers about their virtue, which doesn’t always work, so they approach many carriers until they slip through.

Flow of customers

The graph above is very surprising. If most available customers are non-virtuous then how is the insurance industry profitable? The confusion comes from mixing up an analysis of flow of customers (above, measured probably in thousands) with the stock of customers (below, measured probably in millions). 

Stock of Customers

Most insurance customers do not flow, they are parked inside an insurer’s portfolio, paying their premium every year, filing the odd claim when disaster strikes their lives but mostly making their carrier money. They don’t want to think about insurance and everyone is pretty happy about it. Low churn is a signal (but not a component) of virtuous character. I should be clear, the virtuous can shop too! The non-virtuous are simply overrepresented among shoppers. 

Since it is quite hard to get access to a large volume of virtuous customers, underwriters compete on who is better at finding the line and so running a successful business. But as virtue declines deceit increases. There are many insurers that want nothing to do with the minimum virtue zone and focus only on the easiest to underwrite. 

Finding the minimum is hard

But only concentrating on the most obviously virtuous people is no free lunch since the competition for these customers is intense. One can underprice the morally straightforward risk as much as the complex and the end of a bout of underpricing is always the same: years-delayed, spectacular financial detonation once the pricing error is inescapably obvious3

The problem of course comes down to an inability to abstractly measure virtue except after the fact. Carriers that can reliably identify virtuous customers can afford to simultaneously offer better prices, better commission, better service and generate better returns for investors. There are carriers that do just this. 

Many innovators seek to eliminate moral judgment with data and clever technology. And there are indeed ways of improving the efficiency of moral judgment. For example, some distribution channels are so incredibly trustworthy4 that underwriting is superfluous and in other instances claims data is so complete and transparent that a person’s behavior can be modeled with incredible accuracy. In these instances underwriting merges with risk assessment and classification. When moral judgment ceases to be an important dimension of competition underwriting ceases to exist. 

Villains, however, are always looking to profit from infiltrating unprotected networks and from time to time these lightly underwritten portfolios collapse. When that happens, underwriting by people returns in force to expose the bad hiding among the good. Moral judgment is as complex as humans are clever at deceit. 

Having morals as guides for action under uncertainty is a tremendous human achievement and assessing the quality of those morals is an irreducibly human act. For a long time I never really understood what underwriting was. Now I actually think it’s the most deeply human commercial institution we have. 


1Doing something bad means finding a way to reliably profit from your insurance policy. Insurance fraud is an example but anything that deceives an insurer into underpricing its policies counts.

2  Pays out if you are admitted to the hospital.

3   To pick a price, insurers make an assumption about the claims a portfolio will have. If they get this wrong it usually requires an increase in claims estimates for many years at once, concentrating that cost increase in one financial year. This is the most common way insurers go bust. 

4   To pick a price, insurers make an assumption about the claims a portfolio will have. If they get this wrong it usually requires an increase in claims estimates for many years at once, concentrating that cost increase in one financial year. This is the most common way insurers go bust. 

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