INSURANCE UNDERWRITING PROCESS

The underwriting process is associated with insurance, the same way it is associated with other financial services. It is all about measuring the chances of risks as also the premium needed to cover that risk.

What is the role of an underwriter?

The underwriter's job is to scale the risks and probabilities that may refer to their prospective clients. They are needed to ascertain the worth of your insurance coverage. They would also help you to decide the amount of premium that you need to pay.

The processes of underwriting & segmenting the insured risks may be clear, only after studying the pool of risks associated with them. This is also essential in order to understand the uneven distribution of risks. The underwriting guidelines defined by an insurance company may vary towards deciding the fate of an insurance application. The underwriter may choose to reject an application or may also choose to offer a quote referring the different premium levels. This might also indicate circumstances that involve a variety of exclusions, which mandate certain conditions towards the payment of claims. The underwriting process necessitates prospective clients to pay their premiums to that extent as is required by the insurer towards meeting the unforeseen risks associated with such individuals, in the event that they might occur. Hence, the procedure of identifying risks & explaining them to a client becomes the sole obligation of the insurer.

At times, the insured might just succeed in making the insurer see no reason towards properly justifying the associated risks, thereby inviting a higher expectancy of losses arising out of it. Under such circumstances, the insurer might just need to charge higher premium rates in order to fill the lower returns & save him from insolvency. The insurance companies are subject to huge risks worth billions every year in terms of financial losses arising out of protecting an insured person or a group. Underwriters are there fore needed to focus on every minute detail while arriving at a premium rate for a certain individual or even at offering a policy for that purpose. While doing these the underwriters would also need to keep a track of the steps and measures undertaken by their competitors towards achieving their goals, failing which they might lose their business to their rivals.

The different areas of operation:

The underwriters would certainly like to focus at any of the main branches of insurance namely – life, property & casualty and health.

It is common for the life & health underwriters to specialize at group or independent policies depending on their areas of operation and qualification. In order to decide about the functions of a group policy, the group underwriters would often resort to representatives of the union or the employer. For the property and casualty underwriters, it is quite normal that their operational areas would depend on the nature of insurance they are associated with (eg. personal or commercial insurance), as also the nature of the risk involved. The group underwriter has to keep a check on the overall risk, so that it never crosses the limits. This is dependent on his study of the group patterns. In contrast, the casualty underwriter has to study the contribution of the individual group members and then forward his feedbacks based on his report. With the advent of the modern computers, it has become easier for the underwriters to figure out the different risk factors associated with a prospect & then arrive at a quicker decision regarding their approval of a policy. This fast-track decision-making process is contributing largely towards the overall growth of the capital fund of the modern insurers.

Beware the Dreaded 'Make-Whole': Private Placement Insurance Company Debt.

You're a CFO. Times are good, and you receive an offer you can't refuse - 7-10 year, $100 million term financing. No bothersome collateral. A relatively low fixed-rate coupon for such a maturity - call it 5.50 percent. A pre-negotiated term sheet leading to reduced lawyer haggling and, ultimately, reduced transaction costs. Sounds good, right?

These are the earmarks of the traditional private placement debt market - a corporate debt market provided by U.S. insurance companies that indeed constitutes one of the true cornerstones of American finance. And over the years, many CFOs across the country have in fact signed on the dotted line and have tapped this important market for their corporate debt.

For many, it has been absolutely the correct decision. The private placement insurance company debt markets do provide relatively low-cost, long-term, unsecured financing. However, if the economy suffers, corporate profits swoon and lenders start instituting defaults, a two-word phrase can be heard ringing down the halls of corporate America - "make-whole."

The Refi Pain

You're a CFO, and now times are not so good. Your company is no longer investment grade, and is in default under the financial covenants contained in the private placement debt agreement pursuant to which these long-term, fixed-rate unsecured notes were issued. You've missed your numbers and missed your covenants. The insurance company lenders that bought these notes have told you that they want "out." They demand that you refinance the notes. And, adding insult to injury, they demand payment of a prepayment premium of sorts - the dreaded "make-whole"

"Make-whole" may not sound so bad, but, unfortunately, the "make-whole" amount can be a really, really, big number - a devastatingly large number. For example, for some recent refinancing deals ranging between $90 million to $200 million, the make-whole amount ranged from $13 million to $22 million. Ouch! For some perspective, imagine if you had to pay a $75,000 prepayment premium on your $500,000 home mortgage - it's about the equivalent.

Defining ‘Make-Whole'

Make-whole is the term used to describe the amount over par that the issuer of notes is required to pay in the event the issuer desires to, or, as is quite often these days, is required to, prepay or refinance the notes prior to their stated maturity.

The make-whole amount is calculated by determining the present value of the interest that would have accrued on the notes through their originally stated maturity, all as if the notes had not been prepaid. The present value calculation uses a discount factor, referred to as the "reinvestment yield," equal to the treasury rate corresponding to the remaining maturity of the notes (plus, typically, 25 or 50 basis points).

The reinvestment yield represents what the investor can now theoretically earn by reinvesting the prepaid principal in a relatively safe investment. Not surprisingly, given its name, the make-whole feature is designed to give the investor the benefit of its economic bargain as if the notes were held to maturity and to make the investor whole, notwithstanding the early prepayment.

Further, make-whole is payable not only when the issuer voluntarily prepays the notes for its own internal reasons, such as a recapitalization of its balance sheet or a refinancing to reduce interest expense. Rather, insurance companies insist upon - and private placement loan documents will invariably provide for - make-whole even when it is the insurance companies themselves that call a default and force the issuer to refinance them out.

It is this "forced refinancing" scenario that is most disturbing to CFOs. Paying a premium in the case of a voluntary prepayment is one thing. After all, it is the issuer that is depriving the noteholder of the benefit of the remaining interest-payment stream. But it is quite another matter, from the perspective of the CFO, if his or her company is being forced to refinance the notes because the insurance companies are not willing to waive covenant violations beyond the control of the issuer. It is the payment of a make-whole premium in this context that is most distressing.

Insurance companies will argue adamantly that such yield protection is the price of a relatively low, long-term, fixed rate. Borrowers will argue that the insurance company lenders should not be compensated for the entire portion of the interest they would have received, since they are not making an outlay of cash, and therefore an outlay of risk, during this entire time. But regardless of who is right and who is wrong, it is the CFO that must account for this hit to net income.

Pre-Closing Considerations for the CFO

Before signing onto the issuance of private placement insurance company debt, CFOs should understand the potential extraordinary impact of make-whole in an early refinancing context.

• First, understand the amounts involved. Run some projections assuming prepayment in the first years of the deal, using your best estimates as to where interest rates will be at those times. Understand the extent of the make-whole risk your company is undertaking.
• Second, like any financing, obtain the most lenient financial ratio covenant package you can negotiate. The longer your company stays out of default, the longer you can avoid the dreaded forced refi scenario and reduce or eliminate the dreaded make-whole itself.
• Third, proceed cautiously if your company is especially cyclical or is in an industry sector that could face a downturn. Otherwise, basically sound but cyclical businesses can often stumble on the financial covenants, resulting in a potential forced refinancing.
• Fourth, because make-whole is payable in a voluntary prepayment context as well, consider whether there are any potential transactions or events on even the mid-term horizon that could fundamentally change the company's corporate structure or character. Examples include a potential change of control, a significant equity issuance or other recapitalization or a significant acquisition or divesture. If such events are likely, either build them into the agreement so that they are permitted or carefully consider whether the private-placement market is for you.
• Fifth, consider other long-term financing alternatives, including the public debt markets. Yes, public bonds do typically contain extended no-call periods. Further, even when the bonds become callable, they come with substantial premiums. However, the key difference between public debt and privately placed debt in this regard is that public debt instruments do not contain financial ratio maintenance covenants that give rise to the dreaded forced refinancing scenario. As a result, it is far easier to stay out of default with public debt. The transactions costs may be higher but the make-whole risk is reduced.

When Make-Whole Stares You in the Face

So, what do you do when you are looking at a $15 million make-whole payment in a forced refi scenario? Negotiate. For the most part, experience has shown that insurance companies will forgo all or a portion of the make-whole in exchange for receiving 100 percent of their principal if they sense a true distressed or workout credit.

But, to get to this result, you must either actually be poor or cry poor effectively! Obviously, actually being poor has its own hurdles - first and foremost of which is the ability to obtain refinancing in the first place. If the issuer is in a tenuous position financially, it may be unable to obtain sufficient refinancing to repay principal, much less make-whole.

However, if the issuer can obtain alternate refinancing, crying poor effectively is still tricky. The issuer must demonstrate to the insurance companies that it has just enough collateral or cash flow to refinance the notes at par but not enough to pay any additional make-whole amount. While this can often be the true state of the issuer's financial affairs, it is often difficult to convince the insurance companies of this fact.

Depending upon the gravity of the situation, the insurance companies may waive the make-whole. For instance, a series of failed refinancings is an obvious signal that the issuer has real problems and, if presented with a refinancing that pays principal at par but no make-whole, the insurance companies may very well take that deal.

Often, if cash or collateral is tight, insurance companies will accept deferred subordinated notes or preferred stock or other equity, or simply reduced make-whole, depending upon a range of factors. These include the amount of make-whole involved, the issuer's true (and perceived) financial state, the intransigence of the noteholders and, perhaps, the effectiveness of issuer's counsel.

Also, CFOs are encouraged to be skillful in playing groups of lenders against one another. Commercial banks despise make-whole just as much as the issuer that is obligated to pay it. The banks can place pressure on the insurance companies to accept a refi that pays less than the full make-whole amount. If the issuer can present a picture of true financial distress, some or even great success can often be had.

In this same vein, attempt, with the aid and comfort of other lenders, to subordinate the make-whole portion of the insurance company claims in any intercreditor negotiations-whether before or after default. As a corollary, avoid whenever possible securing the make-whole obligation with any collateral security. The lower the make-whole is in the waterfall of payment, the greater chance for success in avoiding or reducing make-whole. Sometimes, your other lenders can be your best friends.

Richard W. Grice is chair of the Leveraged Capital Group of Alston & Bird, a national law firm headquartered in Atlanta.
(This article first appeared on Financial Executive Online, November 2003)

FOCUSING ON IMAGE QUALITY

One of the most revolutionary features of the Check 21 environment is the development of new image-based depository services for corporations that receive check payments. These services enable a business to capture check images and MICR line information and then to deliver check deposits electronically to a Check 21-enabled banking service provider. The supporting technology can be provided through desktop scanners and imaging software. Alternatively, a business that employs an image-capture system, for processing mailed check remittances, can create electronic cash letters for transmission to its bank.

Already offered by several bank and non-bank providers, these new image corporate depository services should become more widely available in 2005. For any business thinking about moving to these new depository solutions, image quality assurance will be a key factor in evaluating product and service providers. In this article, we examine why image quality is critical in the Check 21 environment and how image quality assurance will be a major differentiating factor in the new corporate depository services coming to market.

Substitute Checks and Image Exchange

Check 21, which went into effect in October 2004, introduced a new negotiable instrument called a substitute check. A substitute check is a paper reproduction of the original check that includes electronically captured images of the front and back of the original check and a reproduction of the original MICR line. A bank of first deposit can create substitute checks from the original deposited paper checks and then truncate the original items. This bank can then electronically transmit check images and MICR line information to a locale near the paying bank, where substitute checks can be printed and presented for payment.

By setting the stage for image-based processing of paper checks, Check 21 also implicitly encourages image-embedded banks to enter into bilateral contractural agreements with each other to present checks by purely electronic means or in "image exchange". In the long run, banks will be able to clear checks more efficiently by eliminating physical transportation of the paper checks.

Check 21 Image Quality and Usability Standards

Image quality assurance is obviously a key aspect of Check 21. Under Check 21 regulations, a substitute check (or image replacement document) is considered the legal equivalent of the original check provided the substitute check accurately represents all of the information on the front and back of the original check at the time the original was truncated. Furthermore, the bank creating the substitute check (or the first bank that takes the substitute for deposit) must make certain that the image captured from the original check meets this legal equivalence requirement.

In establishing image exchange standards, the Financial Services Technology Consortium (FSTC) has been playing a leading role. The FSTC, of which Bank of America is a member, is made up of financial institutions, clearing houses, exchanges, and third-party service providers. In 2004, the FSTC launched an Image Quality and Usability Assurance Initiative to develop an interoperable set of terminology and metrics for check image exchange. In Phase I of this project, the FSTC identified 16 image defects that could result in a check image not being usable. These include such conditions as folded or torn document edge, excessive document skew, image too light, image too dark, image with horizontal streaks, and image out of focus. Such defects could affect the legibility and/or completeness of information digitally represented in a substitute check image. In Phase II of the project, the FSTC will establish image quality and usability metrics to be incorporated into the ANSI X9.100-180-2005 Specifications for Electronic Exchange of Check and Image Data. Phase II is scheduled to be completed in about 18 months.

Another key point to keep in mind is that current experience with imaging shows that most defective images are the fault of the source document (the original check) and are not caused by deficiencies in imaging technology. Checks with excessively dark or complex background patterns, intricate borders or logos, and other "noisy" design elements are more likely to result in unreadable images. Consequently financial institutions, check printers, and businesses that print their own checks need to promote the use of check designs that meet the image quality and usability requirements for image processing. The FSTC estimates that it will be 12-18 months before we see significant levels of image exchange check processing. That provides time for the gradual elimination of check stock designs that are not image friendly.

Image-Based Corporate Depository Services

Image-based corporate depository services enable a business that receives check payments to capture check images and MICR line information and make deposits electronically by sending that data to its bank. One form of this service employs a desktop scanner with imaging software. The operator scans each check, keys in the dollar amount, and validates that the MICR line information has been captured correctly. When the entire deposit has been imaged, the information is transmitted to the bank. The client's account is credited and the deposit is processed. Checks are cleared through the check clearing system using image replacement document processing or through the ACH using accounts receivable (ARC) check conversion for mailed consumer checks.

An electronic cash letter service for businesses - with in-house, image-based remittance processing operations - works in much the same way. Check images and MICR information captured by the corporate lockbox system are converted into image cash letter files that are transmitted directly to the bank. The bank credits the corporation's account and clears the deposited items through the check clearing system or the ACH.

For businesses that receive significant volumes of check payments, these new image depository solutions may provide major benefits, including faster deposit processing, accelerated funds availability, and earlier notification of returned items. In case of disputes, the business has electronic access to check images and can also securely store the original checks for a period of time before destroying them. With either the remote deposit or electronic cash letter service, the corporate customer assumes responsibility for the destruction of truncated checks within the mandated timeframes so that they can't be reintroduced into the check clearing system.

Evaluating Image Depository Services

Both remote deposit and electronic cash letter services obviously depend on image quality assurance and processing controls help to ensure that there are no problems in downstream clearing. Here's a checklist of some of the key image technology and processing issues to consider if you're thinking about moving to an image depository service:

• Image quality assurance engine. Making sure that image quality is satisfactory before images enter the image-processing flow is the best way to ensure that there no problems downstream. Does your service provider offer a software solution for validating image quality as checks are being scanned or for validating images contained within an electronic cash letter file?
• Check 21 compliance. As more banks become image-enabled, opportunities to clear checks via direct image exchange or substitute check presentment will grow. Can your service provider create files for image exchange that meet standards outlined by the FSTC? Is your service provider actively planning to enter into electronic check presentment agreements with other banks? Can your service provider create substitute check cash letters and deliver them to distributed print sites?
• Automated check conversion decisioning. For consumer checks, check conversion is the fastest, most efficient clearing alternative. Does your proposed service include an automated system for determining if checks are eligible for check conversion and converting them into ACH transactions?
• Deposit review. When preparing electronic deposits, you want to be sure that transactions and deposits balance. Does your service provider offer a deposit review function to balance items and total dollars, validate MICR line information, and verify deposit account numbers?
• Transmission security. Security is paramount when sending deposits to the bank electronically. Does your proposed service make use of digital certificates or other security methods to better protect your transmissions and may ensure that deposit files are not altered in transit?

Focusing on the Image

At Bank of America, we're convinced that image technology will totally transform the way banks do business and the way businesses do their banking. Through our participation in the FSTC, we're fully committed to assisting in the development of image quality standards and supporting the new image depository services that are becoming available to corporate customers. Look for more information on image quality and usability parameters in future issues of IdeasLab.

adapted from http://www.gtnews.com/article/5937.cfm