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Underwriting (UW)[1] services are provided by some largefinancial institutions, such as banks, insurance companies and investment houses, whereby they guarantee payment in case of damage or financial loss and accept thefinancial risk for liability arising from such guarantee. An underwriting arrangement may be created in a number of situations including insurance, issues of security in apublic offering, and bank lending, among others. The person or institution that agrees to sell a minimum number of securities of the company for commission is called the underwriter.
The term "underwriting" derives from theLloyd's of Londoninsurance market. Financial backers (or risk takers), who would accept some of the risk on a given venture (historically a sea voyage with associated risks of shipwreck) in exchange for apremium, would literally write their names under the risk information that was written on a Lloyd's slip created for this purpose.[2][3]
In the financialprimary market,securities underwriting is the process by whichinvestment banks raise investment capital from buyers on behalf of corporations and governments by issuing securities (such asstocks orbonds). As an underwriter, the investment bank guarantees a price for these securities, facilitates the issuance of the securities, and then sells them to the public (or retains them for their own proprietary account).[4] This process is often seen ininitial public offerings (IPOs), where investment banks help a corporation raise funds from the public. The underwriter is obligated to purchase the entire issue at a predetermined price before reselling the securities in the market.[5] Should they not be able to find buyers, they will have to hold some securities themselves. To reduce the risk, they may form asyndicate with other investment banks. Each bank will buy a portion of the security issue, and typically resell securities from that portion to the public.[6] Underwriters make their profit from the price difference (called "underwriting spread") between the price they pay the issuer and what they collect from buyers or frombroker-dealers who buy portions of the offering.
The services provided in the process of underwriting include:
Once the underwriting agreement is struck, the underwriter bears the risk of being unable to sell the underlying securities, and the cost of holding them on its books until such time in the future that they may be favorably sold.
If the instrument is desirable, the underwriter and the securities issuer may choose to enter into an exclusivity agreement. In exchange for a higher price paid upfront to the issuer, or other favorable terms, the issuer may agree to make the underwriter the exclusive agent for the initial sale of the securities instrument. That is, even though third-party buyers might approach the issuer directly to buy, the issuer agrees to sell exclusively through the underwriter.
In summary, the securities issuer gets cash up front, access to the contacts and sales channels of the underwriter, and is insulated from the market risk of being unable to sell the securities at a good price. The underwriter receives a profit from the markup, plus the possibility of an exclusive sales agreement.
Also, if the securities are priced significantly below market price (as is often the custom), the underwriter also curries favor with powerful customers by granting them an immediate profit (seeflipping), perhaps in aquid pro quo. This practice, which is typically justified as the reward for the underwriter for taking on the market risk, is occasionally criticized as unethical, such as the allegations that investment bankerFrank Quattrone acted improperly in doling out hot IPO stock during thedot-com bubble.
In an attempt to capture more of the value of their securities for themselves, issuing companies are increasingly turning to alternative vehicles for going public, such as direct listings andSPACs.[citation needed]
Inbanking, underwriting is the detailedcredit analysis preceding the granting of aloan, based on credit information furnished by the borrower; such underwriting falls into several areas:
Underwriting can also refer to the purchase ofcorporate bonds,commercial paper, government securities, municipal general-obligation bonds by acommercial bank or dealer bank for its ownaccount or for resale to investors. Bank underwriting of corporate securities is carried out through separate holding-company affiliates, calledsecurities affiliates or Section 20 affiliates.[citation needed]
Of late, the discourse on underwriting has been dominated by the advent ofmachine learning in this space. These profound technological innovations are altering the way traditional underwriting scorecards have been built, and are displacing human underwriters with automation.Natural language understanding allows the consideration of more sources of information to assess risk than used previously.[9] These algorithms typically use modern data sources such as SMS / Email for banking information, location data to verify addresses, and so on. Several firms are trying to build models that can gauge a customer's willingness to pay using social media data by applying natural language understanding algorithms which essentially try to analyse and quantify a person's popularity / likability and so on, with the premise being that people scoring high on these parameters are less likely to default on a loan. However, this area is still vastly subjective.[citation needed]
Insurance underwriters evaluate the risk and exposures of potential clients. They decide how much coverage the client should receive, how much they should pay for it, and whether to accept the risk. Underwriting involves measuring risk exposure and determining thepremium that needs to be charged to insure that risk. The function of the underwriter is to protect the company's book of business from risks that they feel will make a loss and issueinsurance policies at a premium that is commensurate with the exposure presented by a risk.
Each insurance company has its own set of underwriting guidelines to help the underwriter determine whether or not the company should accept the risk. The information used to evaluate the risk of an applicant for insurance will depend on the type of coverage involved. For example, in underwriting automobile coverage, an individual's driving record is critical. However, the type of automobile is actually far more critical.[citation needed] As part of the underwriting process forlife orhealth insurance,medical underwriting may be used to examine the applicant's health status (other factors may be considered as well, such as occupation and risky pursuits) and decide whether the policy can be issued on the standard terms applicable to the customer's age. The factors that insurers use to classify risks are generally objective, clearly related to the likely cost of providing coverage, practical to administer, consistent with applicable law, and designed to protect the long-term viability of the insurance program.[10]
Underwriters may choose to decline a risk, provide a quotation with adjusted premiums, or apply policy exclusions. Adjusted premiums typically include a loading factor,[11] which accounts for administrative costs, expected claims, and a margin for profit.[12] Policy exclusions, on the other hand, limit the circumstances under which claims can be made. Depending on the type of insurance product (line of business), insurance companies use automated underwriting systems to encode these rules, and reduce the amount of manual work in processing quotations and policy issuance. This is especially the case for certain simpler life or personal lines (auto, homeowners) insurance. Some insurance companies, however, rely on agents to underwrite for them. This arrangement allows an insurer to operate in a market closer to its clients without having to establish a physical presence.
Two major categories of exclusion in insurance underwriting aremoral hazard andcorrelated losses.[13] With a moral hazard, the consequences of the customer's actions are insured, making the customer more likely to take costly actions. For example, bedbugs are typically excluded from homeowners' insurance to avoid paying for the consequence of recklessly bringing in a used mattress.[13] Insured events are generally those outside the control of the customer, for example in life insurance, death by automobile accident is typically covered, but death by suicide is typically not covered.[citation needed] Correlated losses are those that can affect a large number of customers at the same time, thus potentially bankrupting the insurance company. This is why typical homeowner's policies cover damage from fire or falling trees (usually affecting an individual house), but not floods or earthquakes (which affect many houses at the same time).[13]
For all types of insurance underwriting, advice and assistance is often provided byreinsurers, who of course have an interest in accepting risks on appropriate terms. SeeFinancial risk management § Insurance.
Continuous underwriting is the process in which the risks involved in insuring people or assets are being evaluated and analyzed on a continuous basis. It evolved from the traditional underwriting, in which the risks only get assessed before the policy is signed or renewed. Continuous underwriting was first used inworkers' compensation, where the premium of the insurance was updated monthly, based on the insured's submitted payroll. It is also used inlife insurance[14] andcyber insurance.[15][16]
Real estate underwriting is the evaluation of areal estate investment, either of equity ownership or of a real estate loan. The underwriting process generally involves a detailed analysis of expected cash flows, the local market, supply and demand, and risks such as the physical state of the property, environmental or geotechnical risks, zoning, taxes, and insurance. In the evaluation of a real estate loan, lenders assess both the risk of lending to a specific borrower as well as the risk of the underlying real estate. Loan underwriters use various metrics includingdebt service coverage ratio,loan-to-value ratio, anddebt yield ratio to assess out whether the property is capable of making debt service payments.
Forensic underwriting is the "after-the-fact" process used by lenders to determine what went wrong with a mortgage.[17] Forensic underwriting is a borrower's ability to work out a modification scenario with their current lien holder, not to qualify them for a new loan or a refinance. This is typically done by an underwriter staffed with a team of people who are experienced in every aspect of the real estate field.
Underwriting may also refer to financialsponsorship of a venture, and is also used as a term withinpublic broadcasting (bothpublic television andradio) to describe funding given by a company or organization for the operations of the service, in exchange for a mention of their product or service within the station's programming.
Underwriting activity in themergers and acquisitions,equity issuance,debt issuance,syndicated loans and U.S. municipal bond markets is reported in theThomson Financial league tables.[18]
Quotations related toUnderwriting at Wikiquote