What is Underwriting?
The process of ascertaining and calculating the financial risk of an institution or individual is known as underwriting. Generally, the risk is connected with giving loans, insurances, or making investments. The process of underwriting is performed by the underwriting professionals of many financial institutions. This risk is calculated to be taken into account to protect investors, applicants, banks, and the market in financial contracts.
Underwriting is a crucial process in the financial field because of the following reasons:
- It determines the level of risk of an individual or institution.
- Assist investors in making profitable investment decisions.
- Set up fair rates of loans.
- Establishes appropriate premiums to calculate the actual cost of insuring policyholders.
- Assures perfect assessment and coverage.
- It helps decide the amount of premium to cover the cost of insuring the policyholders.
Types of Underwriting:
There are three different types of underwriting, namely loans, securities, and insurance. Let’s discuss each in detail.
1. Loan Underwriting
Loan underwriting is done for determining the risk involved in lending money to potential borrowers. This type of underwriting is done based on four main factors: the borrower’s income, appraisal, credit score, and assets possessed by the borrower. The loan underwriting process is often automated, but in some cases, the appraisal requires a human being known as a loan underwriter. One type of loan underwriting that requires a human is for mortgages. It requires assessment of income, credit score, liabilities, and savings to make a sound decision of lending, and thus, this mortgage underwriting has a response time of a week.
2. Securities Underwriting
Securities underwriting is often related to Initial Public Offering (IPO) and is done for a potential investor. It is done to measure the risk associated with particular securities and their fair prices. The investors are majorly investment banks, and they use securities underwriting to calculate whether an investment is profitable. The process of securities underwriting starts when an investor chooses profitable securities supplied by a company making an initial public offering. After this, the investor sells these securities to other buyers in the market and makes a profit out of such a transaction.
It is also seen that the underwriters who perform this security underwriting form a group called an underwriter syndicate in which they buy securities after assessing the risk to sell them to other investors or brokers who will further resell these securities to other buyers available in the market. The income generated from such a trade is known as an “underwriting spread.”
Securities underwriting is essential because it guarantees that its IPO will collect the required capital and give a premium or profit to the underwriters for their services. This underwriting is done in cases of individual stocks, municipal and government bonds, and debt securities.
3. Insurance Underwriting:
Insurance underwriting can be understood as a procedure of assessing a potential insurance holder for life, wellness, property, and other such insurances. In previous times, medical writing was used in health insurance cases to decide on the amount to be charged for an applicant based on their wellness and health. The insurance companies even had the option to deny any coverage based on the person’s conditions. Still, in 2014, as per the Affordable Care Act, the companies were not permitted to deny coverage and impose any limitations while providing insurance. Thus, the insurance underwriting comes to the rescue as it helps ascertain the risks of filing frequent and extensive claims by the insured individuals and calculating the percentage of coverage to be given to an insured.
Life insurance underwriting is a process that involves the assessment of the risk associated with a potential client. This assessment is done based on the individual’s age, health, medical history of his family, the occupation he is involved in, lifestyles, fitness, and other related factors.
How Underwriting works:
Underwriting is a process that requires intensive research and checks. It involves in-depth research and determination of the degree of risk associated with each party or company. This assessment helps the provider set appropriate lending rates for loans, set premiums that aptly cover the actual cost of providing insurance to the policyholders, and lastly, build a market for securities by rightly pricing investment risks. In cases where the underwriter finds the risk to be too high, he may refuse coverage. The main factor which is focused on in the process of underwriting is the risk. In all the types of underwriting shares, the decisions made are only after assessing the degree of risk associated with a transaction. For instance, in cases of loans, the risk is whether the borrower is capable enough to pay back the loan or default in its payment.
On the other hand, in insurance cases, the risk is of too many policyholders’ claiming the same at the same period. While dealing in securities, the risk factor is that the investments will not provide profits and might result in losses. Let it be any underwriting; the risk is a probability that cannot be ignored. Thus, it is the underwriters’ job to make evaluations and calculations that prevent risks and make the entity make sound decisions that result in its profitability.
Key Takeaways:
- Underwriting is a process in which an investor or institution researches, evaluates, and calculates the risk involved in a financial transaction.
- Institutions hire underwriters to determine these financial risks and ascertain whether a deal is profitable for the entity.
- There are three kinds of underwriting, namely loans, securities, and insurance.
- Underwriting is a crucial process in the financial world because it helps investors make profitable investment decisions.
