Cash Flow Underwriting: Definition, Meaning & Example
Cash Flow underwriting comes into play when insurance companies need to bring in extra revenue but don’t have enough clients to make it happen. This strategy has the potential to be risky when their insurance customers need to use their insurance to cover unexpected events.
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- Cash Flow underwriting offers insurance policies below cost to attract more customers.
- This pricing strategy looks to gain more income from high return investments rather than accurately priced insurance policies.
What is Cash Flow Underwriting?
Cash Flow underwriting is when insurance companies offer plans with a pricing strategy that aims for quantity over quality. This requires them to sell policies below cost to bring in more insurance customers.
It’s considered a high credit risk for mainstream insurance companies to engage in this type of pricing. If it works out to their advantage then they’ll have increased the amount of business. This in turn generates more income which then gets invested in securities with a high rate of return.
How Does Cash Flow Underwriting Work?
This strategy is usually enacted in a soft market when the economic cycle is in a weakened state. During these economic conditions, it’s more difficult to bring in mainstream consumers. To combat this, insurance companies lower their pricing for insurance policies. This is especially true in highly competitive markets.
For example, A car insurance company sells an insurance policy to someone with three accidents on their record for $150,000. If the car owner pays $1,800 annually for their plan but gets in another accident that creates an insurance claim of more than $1800 then the insurance company might take a loss.
This can create better consumer affordability and may help people with barriers to credit access. All while providing relief from collateral pressures for the insurance company. The downside is that the cash flow underwriting solution is very risky due to what’s known as the loss ratio.
The Importance of Cash Flow Underwriting
Cash flow underwriting offers insurance companies an alternative strategy for attracting clients during periods of weaker economic growth. It requires the company to take on a larger risk because these lower priced premiums could backfire if their new clientele start creating insurance claims before the company has a chance to earn money back from their investments. If the insurance company’s loss ratio gets too high while engaging in cash flow underwriting then it could lead to financial issues or insolvency.
The Loss Ratio In Cash Flow Underwriting
When selling an insurance policy below cost, the insurance provider is issuing the policy under the speculation that the higher return on their investment will make up for the low cost of the policy. Insurance brokers know that there will be a certain number of inevitable claims they’ll take a loss on. However, they’re also assuming that a portion of the policies won’t need to be used any time soon based on the forecast of losses.
Instead of banking on a small number of higher-priced safe premiums at safer risk, they’re going for a larger number of lower-cost premiums at higher risk.
An essential metric for determining the financial situation of an insurance company is its loss ratio. The loss ratio is the number of losses incurred compared to the premiums. it’s used as a risk assessment metric. So if an insurance company pays $160 in claims for every $340 worth of collected premiums then its loss ratio would equal 47%. This ratio helps measure an insurance company’s profitability and financial health in general.
Overall, insurance companies can adjust their pricing to reflect market conditions. It’s a way to gain more insurance customers and increase income in the short term but this should be used with caution. If the loss ratio is entirely too high, it can spell trouble for the financial future of the company.
FAQs about Cash Flow Underwriting
What is cash flow underwriting? Why is it a concern for insurance companies?
The cash flow underwriting strategy is a concern for insurance companies because the low pricing of its policies can negatively affect their loss ratio and may have negative accounting implications.
Are wages included in cash flow?
Wages are not included in cash flow.
Can insurance companies make loans?
Yes, but it’s financed against an existing policy.
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