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What is Underwriting

Robinhood LearnJune 18, 2020
Democratize finance for all. Our writers’ work has appeared in The Wall Street Journal, Forbes, the Chicago Tribune, Quartz, the San Francisco Chronicle, and more.
definition

Underwriting is the evaluation of risks associated with a proposed financial arrangement to determine whether they outweigh potential rewards.

🤔 Understanding underwriting

Underwriting is the risk-reward assessment of a potential financial agreement. The process is common among investment banks, insurance providers, and lenders. Underwriters try to determine if the company they represent should enter into an agreement and on what terms. They want to be reasonably confident that the other party will meet the requirements of the contract. The evaluation typically includes a detailed look at someone’s financial track record. For example, before approving a loan, underwriters at a bank evaluate how well the applicant lives up to other financial obligations, such as paying a mortgage and credit card bills.

example

The fictitious gaming site Fantasy Stamp Collecting League wants to sell shares on the stock market. The owners turn to an investment bank to underwrite an initial public offering (IPO). To establish the initial price of the stock, underwriters closely examine the site’s parent company, its financial standing, and interest among potential investors. Finally, the underwriters reach a conclusion and set a price for the new shares the company will offer when it goes public.

Takeaway

Underwriting is like deciding whether to loan your friend money…

Say your friend Curtis wants to borrow $500. Before lending to him, you’re likely to weigh the risks involved: Does he typically pay his debts on time? Does he already owe a lot of other people money? Does he have a job or another plan for getting the cash? Similarly, underwriters consider the risks involved before deciding whether to enter into a financial arrangement with someone.

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Tell me more...

What is underwriting?
What is the role of an underwriter?
What are the types of underwriting?
Insurance underwriting
Loan underwriting
Investment underwriting
What are the steps in the underwriting process?
Insurance
Loans
Investment banking
How long does it take for an underwriter to make a decision?

What is underwriting?

Underwriting involves researching the potential risk inherent in a financial agreement before deciding to assume that risk. It is a common practice among investment banks, insurance companies, and lenders. The process helps companies determine appropriate terms, such as the interest rate on a loan. Sometimes an underwriter’s findings cause the company to reject the application.

The primary concerns of underwriters vary depending on the industry. For example,an applicant’s health is a top priority for companies selling life insurance. For loans and investments, the primary consideration is generally the financial history of the individual or business.

What is the role of an underwriter?

An underwriter analyzes potential risks to determine if the prospective profit of a contract outweighs them. Underwriters generally work for financial institutions, like investment banks, insurance companies, and mortgage lenders. Their job is to try to prevent their employers from entering into dodgy contracts with unreliable parties at risk of defaulting on the agreement.

Successful underwriters must know the industries they work in well. They should possess detailed knowledge of their fields, whether that’s life insurance, mortgage loans, or investment securities. They must uphold the standards of both their industry and their company while applying them fairly and consistently.

What are the types of underwriting?

Three common types of underwriting involve insurance, loans, and securities.

Insurance underwriting

Insurance companies use underwriting to evaluate applicants. For example, people might misrepresent the state of their health to obtain life insurance. Careful underwriting can unearth the truth of someone’s medical condition. If the applicant is too much of a risk, the company may charge a higher premium or refuse coverage. The process could prevent the insurance company from losing substantial sums in claims.

Underwriting is also used to approve and set rates for other types of insurance, such as car insurance and homeowner’s insurance. Auto insurance underwriters carefully review the applicant’s driving record. They also weigh many other factors, including the age and gender of the driver and the type and condition of the vehicle.

Home insurance underwriters may consider someone’s credit history and record of filing claims, as well as the age, condition, and use of the home.

Loan underwriting

If you’ve ever applied for a loan, you’ve encountered underwriting. The bank reviews your application to decide whether lending to you is a risk worth taking. The underwriting process aims to establish whether you are the kind of person who will make loan payments on time. The underwriter also decides the amount of collateral you have to put up in case you fail to live up to the terms of the loan arrangement. Loan underwriting also determines the terms and interest rates you may receive.

Investment underwriting

Investment banks generally conduct underwriting for private companies that want to begin offering stock to the general public. Long before the stock sale, the underwriters play a major role in making sure that the company is prepared to go public.

The underwriters evaluate the organization to ensure it has the right type of management structure for a public company. They also want the company to have certain financial and accounting procedures in place as well as a dedicated team of investment relations experts. Underwriters help companies figure out how much capital they want to raise and the type of securities they should issue.

The underwriters then take the lead in preparing the paperwork required by the Securities and Exchange Commission for new public companies. They meet with several institutional investors to measure interest in the future stock. The underwriter and company then set the price at which the stock will be offered.

Investment banks assume the risk of the stock sale by purchasing the stock from the issuing company and then selling it to the public. In this way, the company receives its needed capital even if the eventual sale to the public is lackluster. However, it’s crucial that the underwriters accurately gauge the risk to their investment bank since it could be left holding stock that few want to buy.

What are the steps in the underwriting process?

This is how underwriters in different industries might typically review your case:

Insurance

Insurance underwriters gather as much information as possible about the applicants. Depending on the type of insurance, they may consider factors like age, gender, and medical or driving history. They may take into account whether someone smokes, owns a dog, engages in risky activities, or works in a dangerous environment.

The underwriter develops a comprehensive portrait of the applicant. Computer models then help the underwriter compile the data and produce a prediction of the applicant’s risk. When it comes to life insurance, if the applicant is likely to live for a long time, it may be lucrative for the company to offer a policy. The company would be likely to make a profit from the monthly premiums paid over the years.

However, if the applicant has a short life expectancy, the underwriter is likely to reject the application. The applicant isn’t expected to live long enough to pay a sufficient number of premiums for the company to turn a profit.

Often people mistake an insurance broker for an underwriter. Brokers sell insurance for one or more insurance companies. They help potential clients figure out the policies that fit their needs and collect application materials. Underwriters are the ones who review the materials behind the scenes to decide whether the company should accept your application and the premiums you should pay.

Loans

When people complete loan applications, underwriters decide whether to extend the loan or not, and on what terms. Underwriters typically rely heavily on the credit history of a potential customer to make their decisions.

Underwriters help the financial institutions they work for offer loans to borrowers who are likely to repay them. If the underwriting process goes well, the bank stands to not only recover the principal from the loan but also make a profit from the interest.

A credit report tells underwriters if applicants have defaulted on other loans, lost a property to foreclosure, or declared bankruptcy. The report also indicates whether applicants are overextended and may have difficulty making monthly payments.

If applicants have an excellent credit score, the underwriter may offer the lowest available interest rate. A below-average but acceptable credit history might result in a loan with a high interest rate. The higher rate is the cost the applicant must pay to compensate the bank for assuming extra risk. If the underwriter deems the applicant too risky, the bank may refuse to offer a loan at all.

Investment banking

When companies decide to list on the stock market for the first time, typically one or more investment banks underwrite the initial public offering (IPO). This means the banks assume some or all of the financial risks should the stock not sell as well as expected. The share of these risks the underwriter assumes depends on the underwriting agreement.

Before an investment bank accepts the company as a client, it performs a careful analysis of the risks involved. The bank wants to be sure that the company will attract investors. It may ask: Is the company at the forefront of a burgeoning industry? Does the company have patents or proprietary hardware or software that will give it an edge over competitors? Does the company have the right kind of leadership to grow and compete with established rivals?

If the underwriting process shows the company to be a reasonable risk, arrangements are made to create and sell stock in the company. The investment bank agrees to purchase the stock at a guaranteed price point, assuring the company it will receive needed capital. This type of agreement is called a firm commitment.

Instead of a firm commitment, an investment bank can offer a best efforts agreement. Under those conditions, the underwriter agrees to sell the securities but doesn’t guarantee it will raise a certain amount of money. This type of agreement removes pressure from the investment bank. But the issuing company is not certain that it will receive as much from the sale of the securities as it needs.

If the investment bank isn’t comfortable assuming the entire risk of the IPO, it can form a syndicate, or group, of underwriters. Each participating bank agrees to sell a portion of the securities, with one bank serving as the lead. The bank hopes to make a profit by eventually selling the stock to investors at prices higher than the guaranteed amount. It’s not uncommon for an IPO to generate enough excitement to send the stock soaring far above its opening price.

Companies often offer their stock at discounted prices to increase the likelihood that investors won’t be able to pass up a bargain. As the securities begin selling rapidly, the news coverage of the IPO usually increases, which in turn may create even more demand for the securities. When the IPO goes well, the value of the stock climbs.

On the contrary, if the underwriting process is inadequate, the company’s stock price may decline after it goes public, as negative information about the company comes to light. For example, investors may not be confident that the company has a sustainable business model. If that happens, investors might ignore the IPO. If the underwriter guaranteed the sale of the securities, then the underwriter is obligated to purchase them. The issuing company receives its capital, but the underwriter suffers a loss.

How long does it take for an underwriter to make a decision?

The time it takes an underwriter to make a decision varies by industry and the complexity of the financial agreement under consideration.

Underwriters at some life insurance companies make a decision on the day you apply. Those companies use computer programs to quickly verify the information you submit. In exchange for offering you a speedy policy without a medical exam, those companies may charge higher premiums.

More traditional life insurance policies require a more extensive interview and possibly laboratory tests or a medical exam. They may need to wait for medical providers to submit records. Underwriters at these companies may take days or weeks to make a decision.

Home mortgage underwriters might complete their work in a few days, but typically, it requires at least a week. The process takes longer if underwriters have to request additional documents. Generally, the better your credit history is, the less digging underwriters perform.

For example, if underwriters are uncertain about your ability to repay a loan, they may ask to see more extensive records of your income and savings. If they encounter something in your history that they don’t understand, they may ask you to explain it in writing. Underwriters prefer to err on the side of gathering too much information rather than too little.

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