Brokers, Brokerage, Moral Hazard, And Underwriting
( Originally Published 1911 )
Brokers and brokerage.—The broker in fire insurance is the individual who represents the insured. He takes charge of the insurance interests of his clients, sees that the proper amount of insurance is secured, the proper kind of policies issued, the rates charged correctly computed, and attends to all the details in connection with that part of the insured's interests. He is paid by commission, which is a certain percentage of the premium paid by the insured. It forms part of the rate of insurance and is deducted by the broker when paying the premium. Although the commission varies in different parts of the country 15 per cent is probably general over a large section of the United States. It may' vary from 10 to 25 per cent and may be more in some cases. It is less than 10 per cent on a few classes of risks where the rates are very low and for that reason the premium also.
The broker first appeared in the business shortly after the great fire in New York City in 1845. While that fire ruined many insurance companies the demand for insurance called a larger number of others into existence than the business warranted. The companies began to solicit business from the brokers and thus the broker became an established factor. There was much opposition at first to the broker, opposition which continued not for a year, but for two or three decades and even later, and is not wholly absent today.
The broker fills a legitimate place in the business of fire insurance, especially in the larger centers where insurance is more or less difficult and technicalities enter largely into the problem. For that reason it is reason-able that there should be a broker to relieve the insured of the many details connected with the business. It is the duty of the broker properly to protect the interests of his clients, and in doing that he needs to know as much as the underwriter who assumes the risk. It should be borne in mind that the tendency of the world is to have a large number of services performed on a commission basis. This is true of all lands where with the growth of wealth business becomes more and more sub-divided into different departments, each department furnishing sufficient employment for a group of individuals to devote themselves specially to its performance.
The intricacy of the business of modern fire insurance makes it a' specialty with which the insured, dealing only with his individual risk, can hardly hope to be familiar. He will be sufficiently employed if he takes care of his own business. These necessities make the demand for the broker legitimate, and he seems to fill the place to the satisfaction of his clients.
Moral hazard.—The question of moral hazard is involved in all commercial transactions where credit enters. It has always been present in fire insurance and is generally considered to be present to an unusual degree as compared with other businesses.
Moral hazard means the possibility that the insured may burn his own property. Judgment differs as to the amount of loss occasioned thereby, but it is sufficiently large to be deserving of the most careful consideration. Probably the most conservative judgment would place the loss from this cause at about one-tenth of the total. It has been placed at one-third, at one-half, and in some cases even higher, but in the best judgment one-tenth would cover the loss.
The simple fact that fire destroys property and this when successfully burned destroys with it the evidences of the self-firing makes it more or less easy to commit this crime. The widest knowledge is sought, using not only the ordinary reports, the fire records, but all other sources of information to keep track of the insured and to form an estimate as to the moral hazard. It is considered, of course, that if the insured's record is not clear on this phase of underwriting then the risk should be declined, since no premium would compensate nor be sufficiently large.
In making the inspection such factors as the general prosperity of the business, the manner in which it is conducted, the condition of the market covering the thing offered for insurance at the time, projected changes in style, the financial standing—in fact everything that can throw any light on the subject is considered, but the problem still remains to-day as insoluble as at first. It is interesting to note that historically the problem was considered almost as serious fifty or seventy-five years ago as it is today. Those were the days before immigration had set in, so it cannot be entirely due to the advent of foreigners.
Underwriting.—From the earliest days of insurance contracts the name of the insurer or insurers has been written at the bottom of the document. The insurers signed their names underneath stating that they would assume only the share of the risk to the amount set opposite their names. From this position of the name insurers came to be called underwriters.
The term is in use today for any person or corporation that assumes a risk involving the principle of insurance.
Now that the various other divisions of the business of fire insurance have been considered, the interesting question remains as to what is embraced under the general term of underwriting. Perhaps a better view can be reached from a negative standpoint :
(a) It is not the mere organization of a fire insurance company.
(b) It is not the care of the financial part of the company's transactions nor the successful management of the details incident to its affairs.
(c) It is not the inspection of risks.
(d) It is not determining the rate to be charged in a given case.
(e) It is not drafting the policy form or otherwise completing the contract or policy.
(f) It is not a knowledge of the law of insurance and the standard policy.
It is not one but a mingling of these things, not allowing any one of them to predominate, and regarding each as a part contributing its portion to the whole.
Underwriting is the ability properly to estimate the factors which must be considered when dealing with a specific risk, and then having carefully considered them to decide to accept or to refuse. The whole problem of underwriting, therefore, lies in this acceptance or rejection.
Problems of underwriting.—There are companies which operate in a limited zone, as the small mutual companies, which in the conduct of their business call for less skill than that of the stock corporations engaging in a world-wide business and attempting to handle all classes of risks that may be offered.
The lines of insurance should be accepted so as to distribute the loss fairly and evenly throughout the classes of risks. Lines must be accepted in such a manner that there will not be an undue amount in a class subject to loss at one fire. If, for instance, there were ten lines of $5,000 each of a certain class and one line of $50,000 it is evident that the burning of the $50,000 risk would entail a loss equal to the burning of the other ten lines. The fundamental principle upon which successful underwriting is based is the ability properly to distribute the lines. The one who places or determines the lines is the underwriter of the company whatever his official name may be. To determine what lines to accept, the amount, the class, the location, calls for the best ability.
In the early days of underwriting lines were accepted for amounts which would astonish the modern underwriter. Modern underwriting is based wholly on the principle of small lines well distributed. In the country the problem is rather what to accept than how much. In the city it is not only what to accept but how much. In the country the conflagration problem does not en-ter, but in the city it is ever present, every city presenting this twofold problem. If it is estimated that a conflagration in a city might burn one hundred blocks then it is evident that $10,000 at risk in each block, would mean a loss of $1,000,000. The practice of underwriting in small lines well distributed is indeed the only safe rule. The underwriter may not always choose.