Introduction to Underwriting - Definition, Types, and Why is it Important?

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Introduction to Underwriting - Definition, Types, and Why is it Important?

By Jupiter Team · · 6 min read

Underwriting is an important function in the world of finance. From insurance to home loans to investment banking, underwriting is everywhere, and it helps lenders understand how much risk they should take and what price they should assume for it.

What is underwriting?

Underwriting is a process that an individual or a business might follow to assume financial risk for a certain fee. This risk mostly revolves around insurance, loans, and investments.

In earlier times when a large portion of goods was sent as consignments on ships, the amount of risk involved was also quite high. To cover this risk, ship owners would document all the details of the goods on board.

Consequently, business owners would shoulder this impending risk for a premium. That’s how underwriting became popular.

How does underwriting work?

Since there is a party assuming risk, underwriting involves, as a part of its process, thorough research and assessment of the risk.

In other words, the underwriter will want to determine the degree of risk that an applicant is associated with before proceeding.

Without this initial evaluation, it will be difficult to set a rate for borrowing of loans, build a market for securities by setting a price on investment risk, or arrive at the right amount of premium to make up for the costs of insuring a policyholder.

Naturally, if there is too much risk, an underwriter has the right to refuse.

By now it is quite evident that risk is the driving force in the process of underwriting. If someone borrows money, then non-payment or delayed payment is a risk.

Similarly, in insurance, too many claims made at one time is a risk. And in the securities market, unprofitable underwritten investments are a risk.

Underwriters try to mitigate this risk by assessing loans to understand how likely someone is to repay and whether there is a security or collateral to fall back on in the case of default.

Insurance underwriters, on the other hand, evaluate a policyholder’s health and try to divide the risk among as many people as possible. Moreover, in Initial Public Offerings (IPOs), underwriting of shares or securities is done so that the company’s value can be measured against the risk of purchasing its securities or shares.

What does an underwriter do?

In simple terms, an underwriter determines the risk-worthiness of a contract. For instance, an underwriter in banking will look at the credit risk of an applicant for a loan. It is not always the simplest thing to do.

Underwriters may have to be more scrupulous and thorough, especially when the degree of risk is much higher.

Read further about what exactly underwriters do in different industries.

Functions of underwriters

Whether it is loans or insurance, an underwriter essentially assesses, and if everything seems favorable, takes up the risk of another individual or business. However, if it seems unfavorable, an underwriter may also deny assuming the risk.

Let us assume that you apply for a loan with ABC Bank and mortgage your house. The mortgage underwriter is going to evaluate the risk of approving your loan by analyzing your repayment history, credit score, and the market value of the house that you have mortgaged.

They will use all this information to ascertain whether your loan should be approved in the first place. If they decide on approval, then a rate of interest will be determined for you and this will depend, to a large extent, on the degree of risk that the underwriter assumes.

If you run a business and are going public for the first time, then you will have an IPO. And here is where the underwriter plays a role.

If you are purchasing an insurance policy, then the insurance underwriter will evaluate your case and try to determine the chances of you submitting a claim by taking several factors into account. It is after this that they will determine your premium.

Different types of underwriting

As you may already know, there are three types of underwriting, which include loan, insurance, and securities.

Loan or mortgage underwriting

Every time you make an application for a loan at the bank, along with your documents, your credit history, bank statements, collateral (in the case of a secured loan), and other factors related to your application are assessed.

Usually, this process is automated unless it needs human intervention.

A human mortgage underwriter is the most common in loan underwriting. This person will go over your assets, liabilities, income, credit history, and credit score. The entire process may take a week or two.

Insurance underwriting

Wondering what is underwriting in insurance? Well, for all types of insurance, an insurance underwriter assesses the degree of risk associated with the prospective policyholder.

For instance, in the case of life insurance, an underwriter will try to understand the risk of insuring you by factoring in your age, lifestyle, occupation, health, the medical history of your family, your hobbies, and any other factors that they may deem fit.

This evaluation will then determine the insurance coverage, inclusions, deductions, and premium. It may also result in a rejection of your application.

Securities underwriting

It is usually investors, particularly investment banks that seek the services of securities underwriters. It is done to understand the price and risk of certain securities that have emerged in an IPO.

This initial underwriting will then decide whether the investment bank would further underwrite the shares issued by the company making the IPO and eventually sell those in the outer market.

Underwriting of shares or securities is needed to enable companies to raise the capital they need through the IPO while assuring underwriters a profit for services rendered. In addition, investors gain from the informed decisions that underwriting lends itself to.

Different types of underwriters

Mortgage underwriters

What is mortgage underwriting?

A mortgage underwriter is the one who reviews your application to ascertain the degree of risk involved. Ultimately, it is their decision to approve or reject your application.

During the review, the underwriter looks at your repayment and credit history and evaluates your mortgaged property’s true value to assess whether it can cover any loss resulting from the default.

Moreover, if your loan is approved, then the underwriter is majorly responsible for fixing the rate of interest that you will pay.

Equity underwriters

Equity underwriters, generally keep an eye on your company’s stocks and their distribution. However, they play an even bigger role during IPOs where companies need their services to decide the price at which they must issue shares.

Investment banks whose underwriters look at the possible demand of the company’s stocks, in turn, seek the assistance of other investors from insurance companies and mutual funds.

The findings from this analysis lead underwriters to fix a price for the IPOs of several organizations. Further, they undertake the guarantee of the purchase of shares. If they go unsold, the underwriters assume that risk.

Insurance underwriters

Two functions are performed by insurance underwriters. First, they evaluate the risk associated with an applicant and decide whether to accept or reject their application.

If they accept, then they also set the premium which is reflective of the risk the applicant carries. Moreover, they issue guidelines related to the policy.

Their main rationale behind these guidelines is to divide the risk among as many policyholders as they can so as to benefit the insurance company.

Insurance underwriters also review any claim submitted by policyholders, arrive at its legitimacy, and decide on the appropriate coverage amount.

Debt security underwriters

Debt security underwriters usually buy, sell, and make a profit. They deal in instruments of debt like corporate and municipal bonds.

They trade either directly or through dealers. Sometimes, they work together, much like an underwriter syndicate.

Example of underwriting

Let us assume that you are purchasing health insurance for yourself and your family. So, you will approach a health insurance company with an application.

Your application will be reviewed by an underwriter who essentially will look at the health risk associated with you.

In the process, you may be asked for information related to your current health, overall health, medical conditions, any pre-existing family conditions, your age, lifestyle, and occupation.

All these factors will help the underwriter understand how likely you are to make a claim and what level of risk you are at.

In some insurance companies, this process is automated. An underwriting software makes an assessment and arrives at a figure for the premium.

What is the main purpose of underwriting?

The purpose of underwriting in different industries is to set the most appropriate price for the risk assumed by underwriters.

In banking, it helps to fix the right borrowing rates; in insurance, it helps to determine premiums and coverage amounts, and in the securities market, it helps to identify the right price for investment risk.

How long does underwriting take?

Automation is key in every industry, and it has taken over underwriting too. What used to take a few weeks or months some years ago can now be completed in a matter of a few days. However, this period can become longer in certain cases.

An underwriter plays quite a critical role in the financial system. The process of underwriting ensures that contracts are made in fair conditions and informed decisions are taken.

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