Definition
Underwriting in finance refers to the process through which an individual or institution takes on financial risk for a fee. This can happen in scenarios like insurance, where an underwriter evaluates the risks of insuring a potential client and determines suitable premium amounts. In a market context, underwriting often refers to a financial institution agreeing to buy unsold shares in an initial public offering (IPO).
Key Takeaways
- Underwriting refers to the process in which investment bankers raise investment capital from investors on behalf of corporations and governments that are issuing either equity or debt securities.
- The Role of an underwriter can include assessing the risk of insuring a particular individual or asset, setting appropriate prices for the risk they are taking on, and assuming the financial risk for liability for such risk in the event of a damaging event.
- In banking, underwriting is also seen where a bank will assess the level of risk to a potential client and uses that assessment to set borrowing terms. It can also involve contracts where the underwriters guarantee payment in case of damage or financial loss and accept the financial risk for liability arising from such guarantee.
Importance
Underwriting is a critical term in finance as it serves as the foundation of the lending and insurance sector.
It involves a comprehensive evaluation process conducted by financial institutions, like banks, investment houses, or insurance companies, to assess the financial capacity, creditworthiness, and the potential risk of a client, be it an individual or a corporation, before granting loans, insurance, or capital market securities.
This process ensures that the financial risks are manageable by accurately pricing these services based on the assessed risk.
Hence, underwriting minimizes the risk of defaults or non-payment, maximizes profitability for these institutions, and maintains marketplace stability.
Explanation
Underwriting is a crucial process in the world of finance that essentially assesses risk. This procedure plays a fundamental role in several financial sectors, such as insurance, equity markets, and loans or credits.
The main purpose of underwriting is to evaluate and quantify the risks involved in a particular financial transaction or agreement, and decide how much coverage the applicant should receive and at what premium rate, if it’s an insurance policy, or whether a loan should be granted and at what interest rate, if it’s a bank loan. In the context of Insurance, underwriters review the risk factors of potential policyholders to determine if they are eligible for the insurance coverage they applied for, setting the price or premium based on the assessed risk.
In the Equity Market, underwriting is mostly seen during Initial Public Offerings (IPOs) wherein underwriters buy shares of a company’s stock at a discounted rate and sell them to the public or private clients, thus managing the risk of raising the funding. Similarly, while granting loans or credits,in underwriting, the lenders review the creditworthiness of the borrower to ascertain the potential risks, aiding them in the decision-making process.
Hence, underwriting forms the basis of making informed investment and lending decisions, managing financial risk effectively.
Examples of Underwriting
Mortgage Underwriting: When attempting to secure a home loan, lenders engage in the process of underwriting to assess the potential risk before approving a mortgage. This process involves evaluating the borrower’s credit history, employment status, income, debt-to-income ratio, and the value of the home being purchased. If the risk is too high, the lender may deny the loan or propose higher interest rates.
Health Insurance Underwriting: Health insurance companies use underwriting to assess the health risk of potential policyholders, using medical history, lifestyle factors, and other health indicators. They then use this information to determine premium rates or if they will offer a policy at all. For example, someone with a chronic illness may face higher premiums than a generally healthy individual.
Securities Underwriting: Investment banks often use underwriting as part of their services when a company wants to issue new securities. The underwriters will thoroughly research the company’s financial health and prospects to assess the viability and potential profitability of the securities. Once the analysis is complete, they decide how much of the securities to purchase and at what price, and then resell these securities to investors. This process is typically seen during Initial Public Offerings (IPOs).
FAQs on Underwriting
What is Underwriting?
Underwriting is a process used by financial institutions such as banks, insurers, or investment houses whereby they assess and measure the risk of a potential business undertaking, such as a loan, insurance policy, or an investment, in order to set pricing that accurately reflects risk.
What does an Underwriter do?
An underwriter evaluates the risk and exposures of potential clients. They decide how much coverage the client should receive, how much they should pay for it, or whether even to accept the risk and insure them. Underwriting involves measuring risk exposure and determining the premium that needs to be charged to insure that risk.
What is the importance of Underwriting in insurance?
Underwriting is critical in insurance because it is the process of evaluating the risk of insuring a home, vehicle, driver, or an individual’s health or life. It determines whether it would be profitable for an insurance company to take a chance on providing insurance to an individual or business. Without proper underwriting, the company may not charge a correct amount for risk and will end up losing money.
What is Underwriting in banking?
Underwriting in banking involves an arrangement under which an investment bank guarantees the issuance of share capital by a company. The investment bank agrees to purchase the entire issue of shares and assumes all the risk. It does this by buying the shares at a discount and selling them at a premium.
What qualifications do you need to be an Underwriter?
Most underwriter positions require a bachelor’s degree. However, some jobs may require a master’s degree. It’s helpful to have a degree in a field such as business or economics, and courses in finance, mathematics, and statistics are beneficial. Some underwriting jobs, particularly those in health insurance, may require a nursing or other medical degree.
Related Entrepreneurship Terms
- Insurance Policies
- Risk Assessment
- Premiums
- Creditworthiness
- Securities Issuance
Sources for More Information
- Investopedia: This site provides in-depth articles about various finance terms, including underwriting.
- Corporate Finance Institute: A professional organisation that offers financial training and resources, including comprehensive information on underwriting.
- Fidelity: A financial services corporation that provides extensive information on various finance-related topics, underwriting included.
- Bankrate: A reliable source offering a rich library of articles on diverse financial concepts, including underwriting.
