DEFINITION of 'Underwriting Risk'

The risk of loss borne by an underwriter. Underwriting risk generally refers to the risk of loss on underwriting activity in the insurance or securities industries.

In insurance, underwriting risk may either arise from an inaccurate assessment of the risks entailed in writing an insurance policy, or from factors wholly out of the underwriter's control. As a result, the policy may cost the insurer much more than it has earned in premiums.

In the securities industry, underwriting risk usually arises if an underwriter such as an investment bank overestimates demand for an underwritten issue or if market conditions change suddenly. In such cases, the underwriter may be forced to hold part of the issue in its inventory or sell it at a loss.

BREAKING DOWN 'Underwriting Risk'

An insurance contract represents a guarantee by an insurer that it will pay for losses caused by covered perils. Creating insurance policies, called underwriting, typically represents the insurer’s primary source of revenue. By underwriting new insurance policies, the insurer is able to collect premiums and invest the proceeds in order to generate a profit.

An insurer’s profitability depends on how well it understands the risks it insurers against, and how well it is able to reduce the costs associated with managing claims. The amount an insurer charges for providing coverage is a critical aspect of the underwriting process. The premium must be sufficient to cover expected claims, but must also take into account the possibility that the insurer will have to dip into its capital reserve. If the insurer is forced to dip into its capital reserve, then it faces an added cost because the capital reserve is supposed to earn a return.

Determining premiums is complicated because every policyholder has a unique risk profile. In order to set an appropriate premium, insurers evaluate historical loss experience for particular perils, examine the risk profile of potential policyholders, and estimate the potential frequency and severity of claims. If the insurer underestimates the risks associated with extending coverage, it could find itself in a scenario in which it pays out more than it takes in. Since an insurance policy is a contract, the insurer does not have luxury of simply not paying the policyholder if it determines that it charged the wrong premium.

The amount of premium that an insurer can charge is also partially determined by how competitive the market that it is operating in is. In a competitive market comprised of several insurers, each individual company will have a reduced ability to charge higher rates. This is because its competitors could charge a lower rate in order to secure a larger market share.

State insurance regulators try to limit the potential for catastrophic losses by requiring insurers to maintain sufficient capital. Regulations prevent insurers from investing premiums, which represent the insurer’s liability to policyholders, in risky or illiquid asset classes. These regulations exist because one or more insurers becoming insolvent due to an inability to pay claims, especially if the claims are the result of a catastrophe such as a flood, can have a severely negative impact on local economies.

Underwriting risk is an integral part of business for insurers and investment banks. While it is impossible to eliminate it entirely, underwriting risk is a key focus for risk mitigation efforts. The long-term profitability of an underwriter is directly proportional to its mitigation of underwriting risk.

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