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What is 'Underwriting'

Underwriting is the process by which investment bankers raise investment capital from investors on behalf of corporations and governments that are issuing either equity or debt securities. The word "underwriter" originated from the practice of having each risk-taker write his name under the total amount of risk he was willing to accept at a specified premium. This centuries-old practice continues, in a way, as new issues are usually brought to market by an underwriting syndicate, in which each firm takes the responsibility, as well as the risk, of selling its specific allotment.

BREAKING DOWN 'Underwriting'

Underwriters also research and assess the risk each applicant presents. This helps to create the market for securities by accurately pricing risk and setting fair premium rates that adequately cover the true cost of insuring policyholders. If a specific applicant's risk is deemed too high, underwriters may refuse coverage.

Underwriting Risk

Insurance is the most common example of underwriting that most people encounter. In order for insurance to work well, risk must be spread among as many people as possible. Underwriting helps insurance companies manage the risk of too many policyholders filing claims at once by spreading out the risk among outside investors. Once an underwriter has been found for a given policy, the capital the underwriter presents at the time of investment acts as a guarantee that the claim can be paid, which allows the company to issue more insurance to other customers. In exchange for assuming this risk, the underwriter is entitled to payments drawn from the policyholder's premiums.

How Underwriting Sets the Market

Making a market for securities is the chief function of an underwriter. Every insurance policy or debt instrument, such as a mortgage, carries a certain risk that the end customer will either default or file a claim. This potentially represents a loss to the insurer or the lender. A big part of the underwriter's job is to weigh the known risk factors and investigate the truthfulness of an applicant's application for coverage in order to determine the minimum price for providing coverage. In this way, underwriters help find the true market price of risk by deciding on a case-by-case basis which policies they are willing to cover and what rates they need to charge to make a profit. They also help exclude unacceptably risky applicants, such as people in very poor health who want life insurance or unemployed people asking for expensive mortgages, by rejecting coverage in some cases. This substantially lowers the overall risk of expensive claims or defaults and allows the agent to offer more competitive rates to the less risky members of the risk pool.

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