An underwriter is a person or institution that evaluates and assumes another party’s risk in mortgages, insurance, loans, or investments for a fee, usually in the form of a commission, premium, spread, or interest. The term underwriting refers to the process of evaluating 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.
Underwriters are critical to the mortgage industry, insurance industry, equity markets, and common types of debt securities trading because of their ability to ascertain risk.
Functions of underwriters
Now, with the underwriter meaning clarified, it can be stated that their primary function is to assess and absorb another party’s risk for a fee or commission. They can also deny taking the risk.
Let us understand this through an example. An individual, Ravi, has applied to secure a mortgage from ABC Bank to buy a house. ABC Bank will have an underwriter assess Ravi’s credit profile comprehensively to understand the risk of extending a loan. Based on this analysis, the underwriter will recommend that the bank either approve or disapprove Ravi’s loan application. If the application is approved, a specified interest rate will be determined for the loan. The interest rate gets higher as the risk increases.
In the equity market, underwriters play a significant role in Initial Public Offerings (IPOs), when a company issues shares and goes public. Similarly, in the insurance sector, underwriters are tasked with determining the chances of a policyholder submitting a claim and setting premiums accordingly.
On an overall level, underwriters help make the financial market fairer and more stable.
What does an underwriter do?
Let us understand what an underwriter does:
1. Risk assessment
Underwriters evaluate the risk associated with a potential policyholder, borrower, or investment. This involves a comprehensive analysis of various factors depending on the type of underwriting involved. For example, in insurance underwriting, factors such as age, health, lifestyle, and family medical history are considered, while mortgage underwriting may focus on factors like credit history, income, and the property being financed.
2. Decision making
Based on the risk assessment, underwriters make informed decisions on whether to approve or deny an application for insurance, a loan, or an investment. They determine the terms and conditions, including the interest rate, coverage limits, or investment terms. The goal is to strike a balance between attracting business and managing risk effectively.
3. Compliance
Underwriters ensure that the proposed transaction complies with applicable laws, regulations, and internal policies. Compliance is a critical aspect of underwriting to mitigate legal and regulatory risks associated with the financial transaction.
4. Documentation review
Underwriters carefully review documentation submitted by applicants, which may include financial statements, medical records, property appraisals, or other relevant information. This meticulous review helps underwriters gather the necessary data to make informed decisions.
5. Communication
Underwriters often communicate with various parties involved in the underwriting process. This may include insurance agents, loan officers, appraisers, and, in some cases, the applicants themselves. Clear communication is essential to gather additional information, clarify discrepancies, and convey decisions.
6. Monitoring and portfolio management
For ongoing relationships, such as insurance policies or investment portfolios, underwriters monitor changes in risk factors. They may adjust terms or coverage based on changes in the risk profile of the insured or the market conditions.
Types of underwriters
Let’s explore the different types of underwriters:
1. Insurance underwriter
Insurance underwriters play a vital role in the insurance industry by evaluating and managing the risk associated with insuring individuals, businesses, or assets. Using a detailed analysis of various factors, insurance underwriters determine the likelihood of a policyholder filing a claim. This analysis includes assessing the applicant's health, age, lifestyle, occupation, and other relevant information. Based on this evaluation, the underwriter sets the premium—the amount the policyholder pays for insurance coverage. A higher risk profile may result in a higher premium, reflecting the increased likelihood of a claim. The insurance underwriter's responsibility is to strike a balance between attracting policyholders and ensuring the financial stability of the insurance company.
2. Mortgage underwriter
In the realm of real estate and lending, mortgage underwriters are instrumental in evaluating the risk associated with providing mortgage loans to individuals seeking to purchase homes or properties. Mortgage underwriters assess the creditworthiness of applicants by scrutinising their credit history, income, employment stability, and debt-to-income ratio. Additionally, they evaluate the value of the property being financed to ensure it aligns with the loan amount requested. The goal is to determine whether the applicant poses an acceptable level of risk for the lending institution. Once the risk assessment is complete, the mortgage underwriter decides whether to approve the loan application, specifying the terms and conditions of the loan, including the interest rate.
Additional read: What is the Greenshoe Option?
3. Loan underwriter
Loan underwriters operate across various types of loans, including personal loans, auto loans, and business loans. Their primary responsibility is to assess the creditworthiness of loan applicants and determine the risks associated with lending money. Loan underwriters analyse the applicant's credit history, income, employment status, debt levels, and other relevant financial information. This comprehensive evaluation helps them make informed decisions about whether to approve or deny the loan application. Additionally, loan underwriters set the terms of the loan, including the interest rate and repayment schedule. Their role is crucial in maintaining a balance between providing access to credit and managing the financial risk for the lending institution.
4. Securities underwriter
Securities underwriters play a key role in the issuance of securities, such as stocks and bonds, into the financial markets. They work with companies or governments looking to raise capital by issuing securities. Securities underwriters conduct thorough due diligence on the issuer, assessing its financial health, business prospects, and overall market conditions. Based on this evaluation, they assist in determining the terms of the securities, including the offering price and quantity. Securities underwriters may also assume the risk of purchasing the securities from the issuer and reselling them to investors. This process is particularly evident during Initial Public Offerings (IPOs), where a private company transitions to a publicly traded one. Securities underwriters help facilitate the efficient functioning of capital markets by connecting issuers with investors and managing the associated financial risks.
5. Equity underwriters
Equity underwriters are responsible for issuing and distributing a company’s stocks on their behalf. Their role is most prominent during the IPO stage when a company goes public and issues shares for the first time. As a company plans to go public, equity underwriters have to assess the price at which it will offer shares to the public. For this, they rely on underwriters at investment banks. While an investment bank works towards ensuring overall compliance with market rules and regulations, underwriters are specifically tasked with analysing the demand for the stock. As a part of their analysis, they reach out to mutual funds, insurance companies, and even institutional investors to assess market demand.
Based on the findings of the underwriter, a company settles on an IPO price. In addition to helping set the IPO value, underwriters also guarantee a certain amount of share purchase and cover for the variance in case the IPO shares see less demand.
6. Debt security underwriters
Debt security underwriters, as their name suggests, operate in the debt security market. They purchase debt instruments like municipal and corporate bonds from issuing entities and sell these instruments to other parties for a profit. The profit earned from these sales is known as the spread. Securities can be sold to other entities directly or through dealers. In some situations, when a bunch of underwriters take charge of the entire process, they are collectively known as an underwriter syndicate.
Example: IPO underwriting
Suppose ABC Ltd., a promising technology company based in India, decides to go public and raise capital by issuing shares through an Initial Public Offering (IPO). In this scenario, the underwriter plays a crucial role in facilitating the IPO process.
1. Selection of underwriters
ABC Ltd. would engage the services of an underwriting firm or investment bank, which acts as the underwriter for the IPO. The underwriter agrees to purchase the entire lot of shares from ABC Ltd. at a predetermined price, providing the company with the assurance of raising the intended capital even if market conditions are uncertain.
2. Due diligence
The underwriter conducts thorough due diligence on ABC Ltd. This involves scrutinising the company's financial statements, business model, growth prospects, potential risks, and overall market conditions. The underwriter aims to assess the risk associated with investing in ABC Ltd.'s shares.
3. Determining offer price
Based on the due diligence, the underwriter collaborates with ABC Ltd. to determine the offer price of the shares. This price must strike a balance between attracting investors and ensuring that the company raises the required capital. The underwriter considers various factors such as market demand, industry trends, and the financial health of ABC Ltd.
4. Underwriting agreement
Once the offer price is set, an underwriting agreement is formalised between ABC Ltd. and the underwriter. This agreement outlines the terms and conditions of the underwriting, including the quantity of shares to be issued, the offer price, and the commitment of the underwriter to purchase any unsold shares.
5. Risk mitigation
The underwriter takes on the risk associated with selling the shares to the public. If market demand is lower than expected, and not all shares are sold, the underwriter is obligated to purchase the remaining shares as per the underwriting agreement. This commitment provides ABC Ltd. with a degree of certainty regarding the funds that it will raise through the IPO.
Additional read: What is Share Market
Underwriters vs agents/brokers
Understanding the roles of underwriters and agents/brokers is crucial in industries like finance. Here’s a breakdown of their differences and functions:
Aspect |
Underwriters |
Agents and brokers |
Primary role |
Evaluate and assume risk, making decisions on acceptance, pricing, and terms. |
Intermediaries who connect clients with insurance or financial products and services provided by underwriters. They do not assume risk. |
Decision-making authority |
Have the authority to approve or deny applications and set terms based on risk assessment. |
Facilitate transactions but do not have the authority to underwrite or make final decisions on applications. |
Risk assumption |
Assume and manage risk on behalf of the insurance company, lender, or issuer. |
Do not assume risk. They act as intermediaries, connecting clients with underwriters. |
Relationship with clients |
Limited direct interaction with end clients. Interact more with agents, brokers, or other intermediaries. |
Directly interact with clients, understanding their needs, and recommending suitable products. |
Compensation structure |
Typically earn a salary or commission from the underwriting institution. |
Earn commissions or fees from the underwriting institution for successfully connecting clients with financial products. |
Market knowledge |
Deep understanding of risk assessment and market conditions to make informed decisions. |
In-depth knowledge of available products and services, as well as market trends to advise clients effectively. |
Licensing requirements |
Often required to have professional certifications and licences specific to the industry, such as insurance or securities licences. |
Required to have licences to sell insurance or financial products, varying by jurisdiction and product type. |
Examples |
Insurance underwriters assess and price insurance risks. Mortgage underwriters evaluate loan applications. Securities underwriters assist in bringing securities to the market. |
Insurance agents sell insurance policies. Mortgage brokers connect borrowers with lenders. Stockbrokers facilitate securities transactions. |
Conclusion
The diverse roles of underwriters in insurance, mortgages, loans, and securities contribute to the stability, fairness, and functionality of various financial markets. Their ability to assess and manage risk is essential for making informed decisions that benefit both the financial institutions they represent and the individuals or entities seeking financial products or services.
