Introduction
Whether you are borrowing a loan from a bank or buying insurance, you must have come across the term underwriting quite often while dealing with such practices. This is because the process of underwriting has significance in the financial industry. When it comes to loans and insurances, the process of underwriting is carried out to determine the risk that each applicant carries and brings to the table. Every time you want to avail a loan or buy insurance you have to undergo the process of underwriting. So what exactly is underwriting and why is it given so much importance? This is what we are going to try to understand by going through the basic concepts behind the process of underwriting and see how it works.
What is Underwriting?
The term underwriting is used for the process through which an institution or an individual takes on a financial risk for a fee or at a predetermined cost. This risk is generally taken in the case of loans, insurance or investments. In accordance with the term underwriting, the term underwriter is used which stands for the person or institution who writes their name under the total amount of risk that they are willing to take for the specified amount of money or premium.
Over time the mechanics have changed, but even now, the process of underwriting has its importance and is considered to be a key function in the financial world. The one important job of an underwriter is to assess the risk of the insurer’s business before granting them the insurance amount. The process of underwriting has proven to be helpful in setting the fair borrowing rates for loans, establishing appropriate premiums, and creating a market for securities by accurately pricing the investment risk.
When a company files for an IPO, the process of underwriting is used to ensure that the company will raise the capital needed and provide the underwriters the decided premium or profit in exchange for their services. Underwriting also benefits investors by helping them to make informed investment decisions.
How does the process of underwriting work?
Conducting thorough research and assessing the amount of risk that the applicant brings to the table are the main factors involved in the process of underwriting. This research helps to set fair borrowing prices for the loans, create a market for securities by accurately setting the pricing for the investment risk, and to establish appropriate premiums to efficiently cover the true cost of insuring policyholders. After the research is done, the underwriter can weigh the risks. If the risk is found to be too high, the underwriter can choose to refuse the coverage.
When talking about underwriting, the basic thing that you should be aware of is that risk is the underlying factor in all underwriting. In case of insurance policies, the risk has to do with the likelihood of too many policyholders filing for claim at the same time. On the other hand, with loans, the risk involves the uncertainty of whether the borrower will repay the loan as agreed prior to availing the loan or will they end up being a defaulter. When it comes to securities, the risk is that the underwritten investments will not be profitable.
In order to determine the likelihood of the borrower repaying the loan as promised and to ensure that enough collateral has been given in case of a default, the underwriters evaluate loans, more particularly mortgages. When it comes to insurance, the assessment of the policyholder’s health and other factors is done by the underwriters to spread the potential risk among as many people as possible. Underwriting securities is most often done through the Initial Public Offerings or IPOs which helps to determine the company’s underlying value as compared to the risk associated with funding its IPO or Initial Public Offering.
The chief function of an underwriter is to create a fair and stable market for financial transactions. Every loan, insurance policy, or IPO carries a certain risk wherein the borrower may fail to repay the borrowed amount which may lead to a potential loss to the lender or the insurer. The process of underwriting works towards avoiding this and the main job of the underwriter is to weigh all the associated risk factors before deciding whether the borrower should be granted the loan, or insurance coverage.
The true market price of a risk is established by the underwriters on a case by case basis. This is based on which transactions they are willing to cover and what rates they need to make a profit. The process of underwriting is also very helpful in exposing the high risk applicants such as unemployed people asking for a large amount of loan, people with poor health requesting for life insurance, or companies that are relatively new in the market but are still attempting an Initial Public Offering or IPO. Such applicants can be denied coverage by the underwriter.
Underwriting reduces the overall risk of expensive claims and defaults. It gives a sense of safety to the loan lenders, insurance officers and investment banks and allows them to offer competitive rates to those with a less risky profile.
What are the types of Underwriting?
Now that we have gone through the basic concept behind the process of underwriting and seen how it works, let us go through the three different types of underwriting— loans, insurance and securities.
Loans The underwriting in loans involves checking the applicant’s credit history, financial records, and the value of the collateral which is offered at the time of availing the loan. All the factors that are checked will depend upon the size and type of loan that is requested and the overall appraisal process may take a few minutes to a few weeks. The most common type of loan underwriting is involved in mortgage loans.
Insurance In insurance underwriting, the focus is on the potential policyholder who is the person requesting health or life insurance. The factors checked in the insurance underwriting may involve the policyholder’s age, health, lifestyle, medical history, occupation, family and other factors which are determined by the underwriter.
Securities Securities underwriting is performed on behalf of the potential investor or often an investment bank to seek the assessment of risk and appropriate price of a particular security. This is more common in the case of Initial Public Offering or IPO. This process ensures that the company’s IPO will raise the needed capital and provide the underwriters with the specified premium.
