Underwriting is the process of vetting risks so only calculated risks are taken to protect investors, banks, applicants and the market in certain financial contracts. In this article, we discuss what underwriting is, what an underwriter does, the main types of underwriting and what elements an underwriter looks at during the underwriting process.
- Underwriting is the process an investor or institution evaluates, researches and quantifies a financial risk.
- The role of an underwriter is to evaluate financial risks, rates and rules for a loan or investment.
Underwriters work in commercial banking, insurance, investment banking and medical stop-loss industries.
What is underwriting?
Underwriting is determining and quantifying the financial risk of an individual or institution. Typically, the risk is associated with providing loans, insurance or investments and is conducted by financial institutions' in-house underwriting professionals. Underwriting has an important function in the financial world because it:
- Assesses the degree of risk of the person or investment
- Establishes fair rates on loans
- Sets the right premiums to properly cover the real cost of insuring policyholders
- Prices investment risk accurately to establish a market for securities
- Ensures proper assessment and coverage
Helps investors make sound investment decisions
What do underwriters do?
An underwriter is a professional who assesses risk and establishes a stable and fair market for financial transactions. An underwriter does this by approving of calculated risk when making decisions on a case-by-case basis. They determine which contracts are worth the risk and the rate they will assign to these cases to ensure they or their employer make a profit.
The following are the top duties of an underwriter:
- Examining applications for insurance, loans, mortgages or IPOs
- Vetting potential borrowers based on their backgrounds, assets, incomes and other factors
- Using software to evaluate risk
- Conducting research and evaluating applicant documents
Approving or declining applications based on research and evaluations
Related: How To Become an Underwriter
Types of underwriting
There are five types of underwriting that are used to assess risks for a variety of important contracts, including:
- Loan underwriting
- Insurance underwriting
- Securities underwriting
- Real estate underwriting
1. Loan underwriting
Loan underwriting involves evaluating and calculating the risks of lending to potential borrowers. Loan underwriters make the assessment of loan repayment based on four main factors: income, appraisal, credit score and asset information.
2. Insurance underwriting
Insurance underwriting is the process of evaluating a prospective insurance candidate for life, health and wellness, property and rental or other types of insurance. It determines the risks of filing large or frequent claims and assessing how much coverage a person can be given, how much they should pay and how much an insurance company is likely to pay to cover the policyholder.
The life insurance underwriting process involves assessing the risk of the potential insurer by evaluating age, occupation, health, family medical history, lifestyle, hobbies and other traits. Health insurance may have restrictions resulting from health factors or pre-existing conditions. Other types of insurance assess the likelihood of accidents, potential damage, environmental impacts and more to determine the scope of a policy.
3. Securities underwriting
Investors and investment banks use securities underwriting to determine how profitable investments—such as individual stocks and debt securities—are likely to be.
In securities underwriting, an investor identifies profitable securities supplied by a company attempting Initial Public Offering (IPO). The investor, then, sells those securities in the market for a profit. Underwriters involved in this process can form an underwriter syndicate, which is a group of underwriters that buys securities to resell them to dealers or investors who will also sell them to other buyers. When this group makes an income from the difference, it is called an “underwriting spread.”
Sometimes the underwriter and securities issuer will make an exclusive deal. In this case, the underwriter will pay a higher price for the bonds and the issuer will make the underwriter the sole agent of the securities. When this happens, the underwriter will be the only agent doing the initial sale of the securities.
The potential investor and underwriter benefit from the underwriting process because the process assesses whether the IPO company will be able to raise the amount of capital required, thus ensuring the underwriters earn a profit for their service.
4. Real estate underwriting
In real estate underwriting, a borrower’s background is assessed, as well as the property they want to get a loan for. The underwriting process will determine whether the property can recoup its value if the borrower cannot pay back the loan.
5. Forensic underwriting
Forensic underwriting occurs when a borrower fails to pay back a loan. In this case, the borrower will be assessed again to determine whether the person can be given a new loan or a refinance.
Related: Your Guide To Careers in Finance
How loan underwriting works
There are four basic elements that an underwriter evaluates during the underwriting process:
Income refers to both gross and net income and is used to estimate whether a borrower's income can cover the monthly payment for the loan. Borrowers must submit IRS Schedule K-1s, balance sheets, profit and loss sheets and personal and business tax returns as relevant to the purpose of the loan.
Appraisals ensure that the property or other purpose of the loan is worth the amount being requested. In this part of the process, an appraiser visits the property or evaluates the purpose of the loan to collect the necessary determining information, such as viability or quality of the investment.
Knowing the borrower’s credit score helps determine if the borrower is reliable in paying on credit, including loans and credit cards. The credit score also provides a borrower's debt-to-income (DTI) ratio, which can be used to estimate whether the borrower can pay back this loan, as well as other existing debts. If a borrower has a good credit score, they can benefit from a lower interest rate.
Read more: How To Calculate Debt-To-Income Ratio
Assets are valuable items a borrower owns that can be sold if they cannot pay back their loan, such as buildings, federal treasury notes, corporate bonds, guaranteed investment accounts, mutual funds and land.
While it is best to score high in all these areas, an applicant can still be offered a loan if they are strong in only one or two. For instance, the borrower may have a high credit score or financial savings but a lower income or minimal assets and still be approved for a loan.
If the underwriter determines the risk is too high to offer a borrower a loan, a loan can be denied. In this case, the underwriter must be able to provide the applicant with a valid reason for the denial. The loan can also be filed as suspended if there are missing documents, but it can be filed as approved with conditions when certain documents, such as tax forms, still need to be submitted.
Related: How Much Do Loan Officers Make?