Underwriting: Definition and Types

What Is Underwriting?

Underwriting is the process in which an individual or institution assumes financial risk for a fee. This typically involves loans, insurance, or investments. The term underwriter originated from the practice of having risk-takers write their name under the total amount of risk they were willing to accept for a premium.

Although the mechanics have changed over time, underwriting continues as a key function in the financial world.

Key Takeaways

• Underwriting is the process in which an individual or institution assumes financial risk for a fee.
• Underwriters assess the risk of insurers’ business.
• Underwriting helps set fair borrowing rates, establish appropriate premiums, and accurately price investment risk.
• Underwriting ensures that an IPO raises the capital needed and provides underwriters with a premium.
• Investors benefit from the vetting process of underwriting.

How Underwriting Works

Underwriting involves researching and assessing the risk each applicant or entity brings before assuming that risk. This helps set fair borrowing rates, establish appropriate premiums, and accurately price investment risk. If the risk is too high, an underwriter may refuse coverage.

Risk is the underlying factor in underwriting. For loans, it involves the borrower’s ability to repay. For insurance, it involves policyholders filing claims. For securities, it involves the profitability of investments.

Underwriters evaluate loans, particularly mortgages, to determine repayment likelihood and collateral availability. For insurance, underwriters assess a policyholder’s health and spread potential risk. Underwriting securities, often through IPOs, helps determine a company’s value compared to investment risk.

Types of Underwriting

There are three types of underwriting: loans, insurance, and securities.

Loan Underwriting

All loans undergo underwriting. Underwriting for mortgages involves assessing income, liabilities, savings, credit history, and other financial circumstances. Refinancing often takes longer due to preferential treatment for deadline-facing buyers.

Insurance Underwriting

Insurance underwriting focuses on potential policyholders. Medical underwriting was used in the past to determine charges and coverage based on health and pre-existing conditions. Life insurance underwriting takes into account age, health, occupation, and other factors.

Securities Underwriting

Securities underwriting assesses risk and pricing for IPOs. Underwriters buy securities from the issuing company and sell them in the market. Individual stocks, government, corporate, or municipal bonds can be underwritten.

Timeline of Underwriting

The time frame for underwriting varies. Personal loans and insurance are generally simple to underwrite. Car loans are managed through an algorithm, while home mortgages require income and credit verification.

Underwriting insurance involves weighing probabilities of claims. Life insurance considers medical history. Securities underwriting, especially for IPOs, involves assessing company financials and can take several months.

What Do Underwriters Look At?

Underwriters examine financials to determine risk and likelihood of losing money. They consider historical data and assess income, employment, credit history, assets, medical history, issuer financial situation, and credit ratings.

How Underwriting Sets Market Price

Underwriting establishes a fair market by assessing risk and determining coverage rates. It exposes unacceptably risky applicants and lowers overall risk. This allows for more competitive rates for less risky propositions.

Etymology of Underwriting

The term "underwrite" comes from marine insurance practices in the 17th century. The insurance company would "under-write" the policy by signing their name and acknowledging consent.

The Purpose of Underwriting Today

Underwriting evaluates the riskiness of a deal. It determines the risk of default, claim, or non-payment. Securities underwriting evaluates newly issued shares and bonds to determine risk-adjusted value.

Can an Underwriter Deny a Policy or Loan?

Yes, if the riskiness is too great, an underwriter can recommend higher rates or deny the application. This must comply with anti-discrimination laws and evaluate objective risk metrics.

Timeline of Underwriting Process

With technological advancements, underwriting has shortened from weeks or months to just days or hours.

The Bottom Line

Underwriting examines financials to determine risk in loans or insurance. It ensures underwriting institutions do not incur more costs than premiums received.