Underwriting is the process through which an individual or institution takes on financial risk in exchange for a fee. This risk typically includes areas such as loans, insurance, or investments. The term underwriter originally came from the practice where risk-takers would write their name under the amount of risk they were willing to accept for a given premium.
Although the mechanics have evolved, underwriting remains a crucial function in today’s financial world.
Key Takeaways
- Underwriting is the process through which an individual or institution takes on financial risk for a fee.
- Underwriters assess the degree of risk involved, whether it’s for loans, insurance, or investments.
- The underwriter’s job helps set fair borrowing rates for loans, establish appropriate premiums, and create a market for securities by accurately pricing investment risk.
- Underwriting ensures that a company filing for an IPO will raise the required capital while providing the underwriters with a premium or profit for their services.
- Investors benefit from the vetting process, helping them make well-informed investment decisions.
How Underwriting Works
Underwriting involves researching and assessing the risk each applicant or entity brings before taking on that risk. This review helps set fair borrowing rates for loans, establish appropriate premiums to cover the true costs of insuring policyholders, and create a market for securities by accurately pricing investment risks. If the risk is considered too high, an underwriter may refuse coverage.
Risk is the central factor in all underwriting. For loans, the risk revolves around whether the borrower will repay as per the agreement or default. With insurance, the concern is whether too many policyholders will file claims simultaneously. Regarding securities, the risk is related to the profitability of the underwritten investments.
Types of Underwriting
There are three primary types of underwriting: loans, insurance, and securities.
Loan Underwriting
Loan underwriting assesses a loan applicant’s credit history, financial records, and collateral offered. Most loan underwriting is automated, but human underwriters are often involved in mortgage approval. Mortgage underwriting typically takes about a week.
Insurance Underwriting
Insurance underwriting examines the potential policyholder, focusing on factors like health, age, lifestyle, and family medical history. The Affordable Care Act prohibits denying health insurance based on pre-existing conditions. Life insurance underwriting continues to evaluate an applicant’s risk to determine coverage terms or rejection.
Securities Underwriting
Securities underwriting is often done by investment banks and focuses on assessing the risk and appropriate pricing of securities related to IPOs. Underwriters buy securities from companies attempting IPOs and sell them in the market, ensuring company capital requirements are met and generating profit from the transactions.
How Long Does Underwriting Take?
The underwriting time frame varies. Personal loans and insurance are relatively simpler, whereas securities require thorough scrutiny.
Personal Loans
Car loans are processed algorithmically and take a few days at most. Home mortgages may take up to 45 days for full approval since they require verification of the borrower’s financial details.
Insurance
Insurance underwriting considers factors like age, geographic location, and claims history. Life insurance policies may take longer due to medical history assessments but generally are decided within a few days.
Stocks and Bond Issues
Underwriting securities might take between six to nine months and involves deeply examining a company’s financials.
What Information Do Underwriters Look at?
Underwriters evaluate each applicant’s risk by comparing it with historical data. For personal loans and insurance, underwriters check the applicant’s income, employment status, credit history, and any collateral. In life insurance, medical history also plays a significant role. For securities, underwriters examine the issuer’s financial situation, credit rating, and any liabilities.
How Underwriting Sets the Market Price
Ensuring a stable market for financial transactions is the core function of underwriting. By determining which transactions are coverable and what rates are required, underwriters help set the market price for risk. They filter out high-risk applicants, enabling institutions to offer competitive rates to low-risk individuals.
Where Did the Word Underwriting Come From?
The term “underwriting” originates from the 17th century, involving the practice of sub-scribing or signing underneath a policy for marine vessels, confirming the insurance risk for overseas voyages.
What Is the Purpose of Underwriting Today?
Underwriting reassesses the riskiness of deals or agreements for insurance policies or loans, ensuring they are appropriately priced for the insurer or lender. Investment bank underwriters evaluate newly issued shares and bonds to determine their risk-adjusted value.
Can an Underwriter Deny an Insurance Policy or Loan?
Yes, underwriters can recommend higher rates or deny applications if the risk is too great, provided they follow anti-discrimination laws and evaluate objective risk metrics.
How Long Does the Underwriting Process Take?
Modern technology has drastically shortened the underwriting process, reducing it from weeks or months to just days or even hours in some cases.
The Bottom Line
Underwriting involves a meticulous examination of financials to gauge the risk and ensure that loans, insurance policies, and securities are accurately priced and viable. This process safeguards lenders and insurers, enabling them to extend services at fairer rates to qualified applicants.
Related Terms: Debt Instrument, Collateral, Credit Score, IPO, Investment Bank.
References
- Business Insider. “Underwriting: The Risk Assessment Process Used in Everything From IPOs to Life Insurance”.
