What Is Underwriting?
Underwriting is the process through which an individual or institution takes on financial risk for a fee. This risk most typically involves loans, insurance, or investments. The term underwriter originated from the practice of having each risk-taker write their name under the total amount of risk they were willing to accept for a specified premium.
Although the mechanics have changed over time, underwriting continues today as a key function in the financial world.
- Underwriting is the process through which an individual or institution takes on financial risk for a fee.
- Underwriters assess the degree of risk of insurers' business.
- Underwriting helps to set fair borrowing rates for loans, establish appropriate premiums, and create a market for securities by accurately pricing investment risk.
- Underwriting ensures that a company filing for an IPO will raise the capital needed and provide the underwriters with a premium or profit for their services.
- Investors benefit from the vetting process of underwriting grants by helping them make informed investment decisions.
What is Underwriting?
How Underwriting Works
Underwriting involves conducting research and assessing the degree of risk each applicant or entity brings to the table before assuming that risk. This check helps to set fair borrowing rates for loans, establish appropriate premiums to adequately cover the true cost of insuring policyholders, and create a market for securities by accurately pricing investment risk. If the risk is deemed too high, an underwriter may refuse coverage.
Risk is the underlying factor in all underwriting. In the case of a loan, the risk has to do with whether the borrower will repay the loan as agreed or will default. With insurance, the risk involves the likelihood that too many policyholders will file claims at once. With securities, the risk is that the underwritten investments will not be profitable.
Underwriters evaluate loans, particularly mortgages, to determine the likelihood that a borrower will pay as promised and that enough collateral is available in the event of default. In the case of insurance, underwriters seek to assess a policyholder's health and other factors and spread the potential risk among as many people as possible. Underwriting securities, most often done via initial public offerings (IPOs), helps determine the company's underlying value compared to the risk of funding its IPO.
Types of Underwriting
There are basically three different types of underwriting: loans, insurance, and securities.
All loans undergo some form of underwriting. In many cases, underwriting is automated and involves appraising an applicant's credit history, financial records, and the value of any collateral offered, along with other factors that depend on the size and purpose of the loan. The appraisal process can take a few minutes to a few weeks, depending on whether the appraisal requires a human being to be involved.
The most common type of loan underwriting that involves a human underwriter is for mortgages. This is also the type of loan underwriting that most people encounter. The underwriter assesses income, liabilities (debt), savings, credit history, credit score, and more depending on an individual's financial circumstances. Mortgage underwriting typically has a “turn time” of a week or less.
Refinancing often takes longer because buyers who face deadlines get preferential treatment. Although loan applications can be approved, denied, or suspended, most are “approved with conditions,” meaning the underwriter wants clarification or additional documentation.
With insurance underwriting, the focus is on the potential policyholder—the person seeking health or life insurance. In the past, medical underwriting for health insurance was used to determine how much to charge an applicant based on their health and even whether to offer coverage at all, often based on the applicant’s pre-existing conditions. Beginning in 2014, under the Affordable Care Act, insurers were no longer allowed to deny coverage or impose limitations based on pre-existing conditions.
Life insurance underwriting seeks to assess the risk of insuring a potential policyholder based on their age, health, lifestyle, occupation, family medical history, hobbies, and other factors determined by the underwriter. Life insurance underwriting can result in approval—along with a range of coverage amounts, prices, exclusions, and conditions—or outright rejection.
Securities underwriting, which seeks to assess risk and the appropriate price of particular securities—most often related to an IPO—is performed on behalf of a potential investor, often an investment bank. Based on the results of the underwriting process, an investment bank would buy (underwrite) securities issued by the company attempting the IPO and then sell those securities in the market.
Underwriting ensures that the company's IPO will raise the capital needed and provides the underwriters with a premium or profit for their service. Investors benefit from the vetting process that underwriting provides and its ability to make an informed investment decision.
This type of underwriting can involve individual stocks and debt securities, including government, corporate, or municipal bonds. Underwriters or their employers purchase these securities to resell them for a profit either to investors or dealers (who sell them to other buyers). When more than one underwriter or group of underwriters is involved, this is known as an underwriter syndicate.
How Long Does Underwriting Take?
The time frame for underwriting varies among different investment products, as the underwriter will have to spend some time examining the risk profile of each investment. Personal loans and insurance products are generally fairly simple to underwrite.
For car loans, the process is managed by an algorithm that compares the applicant to other borrowers with a similar profile. This process takes only a few days at most, and in some cases, it is almost instantaneous.
Home mortgages tend to take longer because the underwriter will need to verify the borrower's income, employment, and credit history, which can take some time. Full approval for a home loan can take up to 45 days, although the underwriting process itself accounts for only a small part of this time frame.
Underwriting insurance is the same as underwriting a loan, except that the insurers weigh the probability and size of the average claim compared to the premiums that they expect to collect. In the case of property and auto insurance policies, this is based on factors like the age of the insured, their geographical location, and their past history of making claims.
Life insurance policies are more complicated because they also account for the insured's medical history. Underwriting life insurance can also take a month or longer, although most decisions are issued in a few days.
Stocks and Bond Issues
Securities are the most complicated products to underwrite. When a company issues a bond or a stock offering, the underwriter (usually an investment bank) examines the company's accounts, cash flows, assets, and liabilities, and checks for any discrepancies. This can take anywhere between six and nine months.
What Information Do Underwriters Look at?
Whether they are lending money or providing insurance, underwriters examine the financials of each applicant to determine how much risk they are taking on and the likelihood of losing money. This is generally done by comparison to historical data: If applicants with a similar risk profile tend to default X% of the time, then the premiums or interest rate will be priced at a rate that assumes an X% probability of default.
Underwriters for personal loans and insurance will look at the available data of the applicant. For loans, they might examine the borrower's income, employment status, and credit history. They will also assess the value of any assets that are used for collateral. For life insurance, they might also look at their medical history, including risk factors such as smoking or drinking.
For securities, the underwriters will look at the financial situation of the issuer, such as their income statements, cash flow, debts, and any other potential liabilities, before pricing a bond or stock issue. They will also examine the issuer's credit rating, the institutional equivalent of a personal credit score.
How Underwriting Sets the Market Price
Creating a fair and stable market for financial transactions is the chief function of an underwriter. Every debt instrument, insurance policy, or IPO carries a certain risk that the customer will default, file a claim, or fail—a potential loss to the insurer or lender. A big part of the underwriter's job is to weigh the known risk factors and investigate an applicant’s truthfulness to determine the minimum price for providing coverage.
Underwriters help establish the true market price of risk by deciding on a case-by-case basis - which transactions they are willing to cover and what rates they need to charge to make a profit. Underwriters also help expose unacceptably risky applicants—such as unemployed people asking for expensive mortgages, those in poor health who request life insurance, or companies that attempt an IPO before they are ready—by rejecting coverage.
This vetting function substantially lowers the overall risk of expensive claims or defaults. It allows loan officers, insurance agents, and investment banks to offer more competitive rates to those with less risky propositions.
Where Did the Word Underwriting Come From?
The term "underwrite" originates in the 17th century when marine vessels would be underwritten for insurance risk for overseas voyages. The insurance company would sub-scribe (literally to write underneath or under-write) the policy by signing their name at the bottom of the document and acknowledging consent that the policy is in force.
What Is the Purpose of Underwriting Today?
Underwriting, whether for an insurance policy or a loan, revaluates the riskiness of a proposed deal or agreement. For an insurer, the underwriter must determine the risk of a policyholder filing a claim that must be paid out before the policy has become profitable. For a lender, the risk is of default or non-payment. Similarly, securities underwriting by investment banks evaluate newly issued shares and bonds to determine their risk-adjusted value.
Can an Underwriter Deny an Insurance Policy or Loan?
Yes, if the riskiness of a borrower or insurance policy applicant is deemed too great, the underwriter can either recommend higher rates or else deny the application entirely - so long as they are not breaking any anti-discrimination laws and are only evaluating objective risk metrics.
How Long Does the Underwriting Process Take?
With the advent of information technology, the underwriting process for insurers and lenders has shortened from a matter of weeks or months to just a few days or even hours in some cases.
The Bottom Line
Underwriting is the process of examining the financials of a loan or insurance application to determine how much risk they pose to a lender or insurer. This usually means checking the applicant's income, assets, and credit history to determine the likelihood that they will end up costing the underwriting institution more than they pay in premiums.