What is Underwriting?
This is a process by which an institution or individual collects a fee to take on financial risk. The risk in underwriting can be anything, but it is mostly associated with insurance, loans, and investments. Before assuming a risk in underwriting, the underwriter will have to conduct different research and assess the degree of the risk in each entity. This helps in setting rates for loans, creating a market for securities by setting the right price for investing risk and establishing appropriate premiums to cover the cost of insuring policyholders. For higher risks, underwriters may refuse coverage.
Underwriting Risk
The main factor in every underwriting is a risk. With the loan, the risk is whether the borrower will repay as agreed or will default on the loan; in case of insurance, the risk is whether there will be claims from one or more policyholders at once; and the risk with securities is whether the underwritten investments may not be profitable. What an underwriter does is to evaluate the loans (especially mortgages) to see if that will be enough collateral in case the borrower refused to pay as promised or default. The underwriters may have to seek to assess health policyholder and other factors to extend potential risk to as many people as they can. The underwriting securities are usually done with IPOs (initial public offerings), which helps to determine the worth of the underlying company and compared to the risk of funding the IPO.
How Underwriting Sets the Market
The main function of an underwriter is to create a stable and fair market for financial transactions. Every insurance policy, debt instrument, or IPO carries a certain risk that may either be defaulted, filed a claim or failed to pay by the end customer. This shows that the insurer or lender is at risk and may lose. What an underwriter has to do is to know the weight of the risk factors and research on the truthfulness of the applicant to know the minimum price to pay for providing coverage.
The job of underwriters is to establish the true market price of the risk they want to cover, and they need to determine the rate to charge to make a profit. They also find a way to exclude risky applicants by rejecting their coverages like unemployed people looking for expensive mortgages or low health people seeking life insurance or unready companies attempting an IPO. This help to reduce their risks of expensive claims and this gives rise to competitive rates to investment banks and insurance agents.
Types of Underwriting
As noted above, there are three types of underwriting, which are underwriting for loans, insurance, and securities.
Loan Underwriting
No matter how small a loan is, it has to undergo a form of underwriting. Underwriting is automated in many cases, and it involves appraising financial records, credit history, and the collateral value in addition to other factors that depend on the purpose and size of the loan. The process can be a simple one taking a few hours or a complex one taking days or weeks. Especially when a human underwriter is involved. The most common type of loan underwriting which requires a human underwriter is the mortgage underwriting, and it is what most people face in their life. The underwriter assesses savings, credit history, income, liabilities (debt), credit score and several others.
Insurance Underwriting
The focus of the insurance underwriting is on the potential policyholder; this is the person seeking life or health insurance. Back in the days, an underwriter uses the medical underwriting to charge an applicant based on health and seeking health insurance. This will help determine whether the applicant will be able to pay or not. Based on the Affordable Care Act in 2014, underwriters are not allowed to use a client’s pre-existing conditions to allow or deny coverage. What they watch out for is the lifestyle, occupation, hobbies, age, health, family medical history and other factors under the life insurance underwriting. Life insurance underwriting is not based on health conditions like health insurance underwriting.
Securities Underwriting
The security underwriting seeks to assess to the risk and the right price to ask for the security; this is often related to an initial public offering (IPO). This is often done on behalf of a prospective investor, often an investment bank. With the underwriting process result, the investment bank would underwrite securities issued which are issued by the company and then sell those written securities in the market.
Underwriting can involve individual stocks, corporate, government, or municipal bonds in the financial market. Underwriters purchase these securities from the investment band and resell them for a profit to either dealers or investors.
